Chapter 12
Credit Value Adjustment
The last section focused separately on credit exposure and default probability. Now we proceed to combine these two components in order to address the pricing of counterparty credit risk via CVA.1 We will see that under certain commonly made assumptions it is relatively simple to combine default probabilities and exposures to arrive at the CVA.
Accurate pricing of counterparty risk involves attaching a value to the risk of all outstanding positions with a given counterparty. This is important in the reporting of accurate earnings information and incentivising trading desks and businesses to trade appropriately. If counterparty risk pricing is combined with a systematic charging of new transactions, then it will also be hedged generated funds that will absorb potential losses in the event that a counterparty defaults. Counterparty risk charges are increasingly commonly associated with hedging costs.
For the purpose of this chapter, we will make three key assumptions that will greatly simplify the initial exposition and calculation of CVA. These aspects will then be dealt with in more detail in the remaining three chapters in this section. The key assumptions are:
- The institution themselves cannot default. The first assumption corresponds to ignoring the DVA (debt value adjustment) component, which is discussed in the ...
