Counterparty credit risk (CVA/DVA)

In the post GFC environment, greater focus has been given to the impact of counterparty credit risk. The notion of counterparty credit risk is defined by the risk that a party to a financial contract will fail to fulfil their side of the contractual agreement.

Under IFRS 13, both Credit Value Adjustments (CVA) and Debit Value Adjustments (DVA) need to be calculated dependent on whether the financial instrument is an asset or a liability:

  • CVA is the credit adjustment for a derivative that is “in-the-money” i.e. an asset, and reflects the credit risk of the counterparty (likely the bank).
  • DVA is the credit adjustment for a derivative that is “out-of-the-money” i.e. a liability, and reflects the own credit risk of the reporting entity.

When considering credit risk there are a number of factors that can influence the valuation including:

  • time: the longer to the maturity date the greater the risk of default
  • the instrument: a forward exchange contract or a vanilla interest rate swap will carry less credit risk than a cross currency swap due to the exchange of principal at maturity
  • collateral: if collateral is posted over the life of a financial instrument then counterparty credit risk is reduced
  • netting: if counterparty credit risk can be netted through a netting arrangement with the counterparty i.e. out-of-the money valuations are netted with in-the-money valuations overall exposure is reduced.

There are numerous methodologies when considering the calculation of CVA/DVA with the appropriate methodology determined by the size and sophistication of the entity’s holding of derivatives.

How Hedgebook helps:

Hedgebook has a CVA/DVA module to keep the auditor happy. In line with the Hedgebook “demographic” we have deliberately kept the CVA module towards the simpler end of the CVA calculation spectrum. We use the current exposure method which we feel is appropriate for vanilla instruments such as FX forwards, FX options and interest rate swaps for an entity using these instruments for hedging purposes.

The module is broken into the following steps:

  • Creating new credit curves (both for the counterparty to the transaction and the company’s own credit).
  • Managing previously created credit curves
  • Assigning credit curves to instruments
  • Running the CVA/DVA report