Credit Value Adjustment

[sipanivishal]

Hi David,

I am unable to understand Credit Value Adjustment concept ...can you please explain it in different or elaborate on your screencast.
Can you add on Irat_swap_mcs Spreadsheet and show ECE and PCE profiles mathematic.?
What is the difference between Msster netting agreement and Netting agreement?Is MNA in the syllabus ?
Page number 79 , study guide credit risk .....can you intuitively explain the summary inplication of relationship between interest rate and Value of debt?
Page number 82 please explain the formula for payoff to market maker.....I am unable to derive it ? What does :invocation of cross default clause mean ?

Thanks
Sipani

 

[David Harper CFA FRM]

Hi Sipani,

CVA = value/price of counterparty risk; the risk the counterparty will default. If derivative contract has value of X based on discounted cash flow, etc, but does not not include risk of counterparty default, then X - CVA is "true" value that incl. counterparty risk.

Can you add on Irat_swap_mcs Spreadsheet and show ECE and PCE profiles mathematic.? I will try, it is just a matter of time...

Netting agreements: MNA is not in the syllabus. MNA connotes the ISDA Master Agreement, a standardized document that can collect (subsume) multiple individual netting transactions. For our purposes, only the "netting" concept is relevant

Can I come back to 79/82? I don't have pithy answers and I really need to get the investment notes published today, I will revisit this....

David

 

[David Harper CFA FRM]

Hi Sipani

Page number 79 , study guide credit risk .....can you intuitively explain the summary inplication of relationship between interest rate and Value of debt?

Regarding p 79, this refers to Stulz 584 but the first two depend on their particular scenario and I'm not sure they are easy to generalize (e.g., speed of mean reversion impact is arbitrary here). The third should be remembered: that higher rates imply lower debt value and that greater interest rate volatility, if higher, makes the debt more risky and less valuable.

Page number 82 please explain the formula for payoff to market maker.....I am unable to derive it ? What does invocation of cross default clause mean ?

That's Stulz adding default risk to a swap. The Market Maker (MM) enters swap with a risky credit, where value of risky credit is V. MM pays fixed (F) and receives floating (S). Without any default risk, we have value to MM of:

= Receives - Pays (in a swap. as they net, value will be +/-)
= MAX(S-F,0) - MAX(F-S,0)

See how the above reflects the swap to the MM; one of the terms is zero, the other is the net swap payment
Now Stulz adds default risk. To our MM, default risk does *not* matter in regard to PAYING only receiving. And, following the structural theme of stulz, default is when the value of risky credit is less than what is owed: IF V < S. So, if V < S, then MM receives

MAX(MIN(S,V)-F,0) instead of MAX(S-F,0). And now,
MAX(MIN(S,V)-F,0) - MAX(F-S,0)


The 'cross default clause' allows a counterparty to terminate if the other has defaulted on some *other* obligation ("Cross default specifies that if a party to a Master Agreement defaults in any borrowed money obligations to anyone in excess of an agreed dollar amount, the other party to the Master Agreement can terminate all transactions under the Master Agreement"). This is to protect the counterparty from disadvantage if another is first to negotiate/etc on default. But, frankly, for our purposes the "typical" ISDA events (per Meissner) are more relevant:

Bankruptcy
Obligation Acceleration: becomes due early
Obligation Default
Failure to Pay
Repudiation/Moratorium: disclaimed or challenges
Restructuring

Thanks, David

 

[Eesh]

What does CVA exactly means? And what is meant by xVA?

 

[Flashback]

Bad "debt" expense posted by a creditor side whereas word debt might be referred to any financial instrument held in portfolio and a CVA is exactly a credit risk expensed in $.
A sign x in later means that value adjustment might not be related on CVA only. For example it may be referred to DVA in bilateral contracts which has an opposite prefix for party affected by CVA.

 

[Eesh]

How is CVA priced into a derivative transaction ?
Is it included in the close-out amount or is it paid during the life of the the derivative transaction?

 

[Flashback]

CVA is beared by side with positive value in contract and may appear at any stage during a life of contract. For OTC derivatives which are not marked-to market on frequent basis through CCP, it might be included in addional collateral call value but often may be not paid at all since it is related to an unexpected loss given a debtor's ability deterioration or even an assumption of such deterioration.
It may be mitigated through various actions such as netting (CVA - DVA), collateral requirement or decreasing of EAD to particular debtor.

 

[Nicole Seaman]

What does CVA exactly means? And what is meant by xVA?

@Eesh

In addition to Flashback's helpful response, we also encourage you to use the search and tag functions in the forum to look for the answers to concepts that you have questions about. There is over a decade of FRM discussions in the forum and many times you can find the answer to your question quickly by searching the discussions that are already in the forum rather than posting a new thread. Please also do not post in the "Today's Daily Questions" section, as this is only for admins to post our daily practice questions. I've moved your post out of that section and to this thread that discusses credit value adjustment (CVA).

Search: https://forum.bionicturtle.com/search/?type=post
Tags: https://forum.bionicturtle.com/tags/

Nicole

 

[Eesh]

Thanks @Flashback and @Nicole Seaman !