CVA adjustment

[shanlane]

Hello,

I watched video 6a and also read the two chapters it was based upon. The example on slide 64 of that video absolutely boggles my mind. It seems to be making two adjustments for the same thing, but I know this cannot be right. The math is simple, 5-2=3, (or 2+3=5) but what do each of these three quantities actually represent? Is this two downward adjustments (102-(2+3)) or one downward adjustment and one upward adjustment(100-5+2)? Neither?

While we are on the subject, could you briefly explain what the prices of 102, 100 and 97 actually represent?

Thank you!
Shannon

 

[David Harper CFA FRM]

Hi Shannon:

This document should help with the mid-market valuation: http://db.tt/0E7NXWRj
e.g., "To arrive at a swap rate for a non-dealer client, a dealer typically adds certain costs to the mid-market rate. This model of pricing a swap is called mid-market pricing with adjustments.
Adjustments can vary depending on the counterparty and the type of transaction, and may include adjustments for credit risk, hedging costs, administrative and other costs, liquidity, and a profit margin."

In regard to the example, it may help to start with:
The implied mid-market value estimate without any counterparty (credit) adjustments = 102
i.e., this is 1. a dealer rate that is market-based and without regard to individual counterparty differences and
2. like the swap valuation in Hull, priced to assume no counterparty risk.

Except, it trades or quotes at 100 because the dealers perceive the average (generic) yen receiver to be unequal to the dollar receiver with respect to counterparty default.
So generic swap value of 102 - generic counterparty adjustment (bias against yen payers, if you will) of 2 = 100
.... This is what the author calls "hypothetical" because it reflect current dealer pricing.

Now "actual" counterparties enter the swap, except the yen payer is below average, and represents more counterparty risk then the average yen payer. Their counterparty risk (CVA) is estimated at 5.0. So the value is adjusted to 102 (i.e., no counterparty CVA adjustment) - 5 (CVA adjustment for this actual counterparty )= 97; or,

102 - 2 = 100: value adjusted for hypothetical (average) yen payer; correct when two average (dealer) counterparties transact the swap
100 - 3 = 97: value after adjusted to the actual (non-dealer) yen payer

I hope that helps, I totally agree that the source text somehow makes this 5x more confusing than it is! David

 

[shanlane]

Thanks!!

Shannon.