IRC vs CVA

[Raj_S]

Hi David,

Probably I am jumping the gun here but this is a question lingering in my mind for a while.
What is the difference between Incremental Risk Charge(IRC) and CVA. Doesn't both look at the credit migration migration risk and hence isn't there an overlap?. Is it that IRC is limited only to trading book products with embedded credit risk such as CDS, CLN etc and CVA is for entire spectrum of products(minus relevant hedges).

Thanks
Raj

 

[ShaktiRathore]

The capital requirement for IRC is calculated from the impact of credit events (defaults or migrations) that may occur during the capital horizon; the standard usage is a one year horizon and a 99.9% confidence level. The capital charge is incremental because VaR does not take these events into account. The IRC has been defined to take into account the debtor risk of default and its credit migration risk (with both direct and indirect consequences).
CVA is defined as the counter parties valuation adjustment. So it takes into account the change in net exposure of one counterparty to the other counterparty. Its given by CVA=Ea*Sa-Eb*Sb where if A and B are two counter parties Ea is net exposure of B to A and Sa is the mean loss rate of A(EL*PD) which reflects the credit risk of the party A and thus the potential loss that B can suffer at the time of payment by A to B. Similarly Eb is net exposure of A to B and Sb is the mean loss rate of B(EL*PD) which reflects the credit risk of the party B and thus the potential loss that A can suffer at the time of payment by B to A. In this way after considering the risks of both the parties and net exposures we find the net exposure that one party holds to the other. If CVA is positive that means Ea*Sa>Eb*Sb that net credit exposure of B to A is more and thus potentially is on the risky side of losing on some part of payment while A has negative net credit exposure to B and does not has anything to loss. Thus we add this CVA to net exposure of B to A to get overall net exposure of B to A to adjust for the credit risk of A.

Clear from above definitions IRC calculates net capital charge after taking into account the VaR and the potential future credit exposures due to debtor's risk of default and its credit migration risk. Its possible due to unforeseen future circumstances the risk of default and migration risk increases in future so to take this into account the IRC is used to calculate the net capital requirement after adjusting VaR to this unforeseen circumstances. Whereas CVA simply calculates the net credit exposure that is the net exposure faced by either counterparty depending on the credit risks and exposures of the counter parties in the contract.

thanks

 

[Raj_S]

Thanks Shakthi.
So in summary CVA is primarily for OTC derivatives (part of Trading book) where there is counterparty credit migration risk while IRC is kind of banking book RWA equivalent for countering regulatory arbitrage - i.e. moving banking book products to trading book to get favourable capital treatment !!! . Hopefully I captured it correctly

 

[ShaktiRathore]

Yes CVAs are for OTC credit risk measurement while IRC is for capital charge calculation(revised Var Basel II).

thanks

 

[MM01]

Can anyone suggest a spreadsheet that sets out the IRC calculation?