CVA increase/decrease with Credit spread

[David Harper CFA FRM]

HI @nc27 if you don't mind, next week i will be reviewing our new Gregory counterparty credit risk Study Notes (I am very excited for this!), which contains this topic of course. So i've bookmarked your question (since I can't immediately answer the two doubts at first glance) and plan to answer while I'm reviewing the note. Thanks for your patience!

 

[nc27]

HI @nc27 if you don't mind, next week i will be reviewing our new Gregory counterparty credit risk Study Notes (I am very excited for this!), which contains this topic of course. So i've bookmarked your question (since I can't immediately answer the two doubts at first glance) and plan to answer while I'm reviewing the note. Thanks for your patience!

Super! thanks @David Harper CFA FRM for taking my doubts into consideration, have a nice day

 

[abhinavkhanna]

Hi @David Harper CFA FRM ,

I have two doubts that bothered me for a bit with respect to this topic.... say I have a derivative instruments portfolio (and netting condition as per my ISDA) composed of european options and irs swaps..... say that my exposure at the time of valuation represents an asset (+100$ in total, but then, individually, some intruments represent liabilities and others represent assets). Now, I am a risky company (rated bbb) and my financial counterparty is well rated (aa+) so that we will observe differences in cds spreads.

1) First doubt, is it possible to get a negative BCVA on the portfolio (DVA > CVA) ?

2) Second doubt, how can we interpret, from an accounting perspective, the fact that the bilateral adjusment might increase the company asset value:

-> for example if my bilateral adjustment on the portfolio is -10$ then I will get risky value = risk free value - BCVA = $100 - (- $10 ) = $ 110.

If my above reasoning is consistent, how companies take into account those bilateral adjustments? (as required by IFRS 13)
the thing is, it would implies that a more risky companie could take advantage of a lower credit rating as the value of its assets might be artificially inflated.

I really hope you can help me on this one,
Thanks you!

Hi @nc27,

I can try to answer the above-mentioned doubts

a) Yes, it is possible to get a negative bCVA on the portfolio in case the creditworthiness of the party (in this case risky company rated BBB) decreases (due to for eg poor quality of collateral posted, higher PD, wider credit spread, etc) this is an increase in DVA (aka, we are riskier to the counterparty) and somewhat counterintuitively this increases the value of the position from our perspective
Even if we reference CDS spread the formula is BCVA = CVA - DVA = - EPE * Spread(c) - ENE * Spread(p). If our creditworthiness decreases Spread(p) on CDS will increase resulting in DVA > CVA

b) I am not sure how companies take into account those bilateral adjustments currently. But as per a reply by @David Harper CFA FRM
If a bank incurs a higher capital charge for higher CVA (as higher CVA is greater counterparty risk), then mathematically an increase in DVA lowers the bCVA and ought to reduce the capital charge. But the point of the statement is that Basel did not want to allow for such an awkward outcome: you shouldn't be able to lower your charge by becoming more risky, even if that does lower your bCVA
I was able to retrieve this article from one of the threads but it seems a little outdated (https://trtl.bz/fasb-finanical-instruments-subtopic-825)

Thanks