Gaining From Your Own Default – Counterparty Credit Risk And DVA
Posted: 8 September 2011
Counterparty credit risk is the risk that a counterparty in a financial contract will default prior to the expiration of the contract and fail to make future payments. Counterparty risk is taken by each party in an over-the-counter (OTC) derivatives contract and is present in all asset classes, including interest rates, foreign exchange, equity derivatives, commodities and credit derivatives. Given the recent credit crisis and the high profiles failures such as Lehman Brothers, the topic of counterparty risk management has become critically important for many financial institutions and derivatives users.
CVA (credit valuation adjustment) is a traditionally applied adjustment to correct the value of derivative contracts for counterparty risk. CVA accounts for potential future losses due to an institution’s counterparties defaulting.
Historically, CVA charges have often beenincorporated into transactions in favour of the stronger credit quality counterparty. For example, banks trading with corporate counterparties have for many years charged CVAs linked to the credit quality of the corporate and the exposure in question.
Recent accountancy rules have also given importance to CVA as a key element in the reporting of accurate earnings information. Accounting standards require an appropriate mark-to-market of derivatives positions including the possibility of future defaults. For example, FASB 157 and IAS39 define fair value and require banks to remove from the risk-free value of derivatives positions the CVA or expected loss associated with future counterparty defaults.