Future of counterparty credit risk lies in CVA
Banks need to adopt a market-based approach to standardize their treatment of Credit Value Adjustments in compliance with Basel III regulations. November 09, 2011 | Jon GregoryThe global financial crisis has created a strong emphasis on the Counterparty Credit Risk (CCR) of OTC derivatives instruments. In recognition of this, banks have been improving their practices around CCR. In particular, the use of CVA (Credit Value Adjustment) to facilitate correct pricing and management of CCR has increased significantly. Indeed, many banks have “CVA desks” that are responsible for pricing and managing CVA across the trading functions. Whilst accounting rules require banks to report CVA, there is a large divergence with respect to its actual calculation. A growing trend in recent years has been to treat CVA as a market-implied quantity, and to hedge the resulting changes so as to minimise CVA volatility. This “market based” approach is typically used by large dealer banks with large and complex derivatives books. A second, still prevalent, approach to quantifying CVA is an “actuarial” method based largely on historical data rather than on market-implied variables. The actuarial approach tends to be favoured by banks whose derivatives books are not so large and complex, ultimately representing a less significant risk for the bank as a whole. The current divide between market based and actuarial approaches is problematic since the latter approach tends to lead to valuations that are significantly smaller (potentially by many multiples). This is not so surprising since the market-implied CVA represents a cost of hedging CCR whilst the actuarial CVA is an average assessment of the future uncertain counterparty default losses. However, given the significance of CCR, it is strange that different banks may report their CVA with such differing methodologies and results. The Basel III global regulatory standard for banks aims to correct the imbalance in CVA approaches. Under Basel III, banks must capitalise for CVA volatility according to the market-implied approach. Whilst the timescales for implementation of Basel III ... Please login to read the complete article. If you already have an account, you can login now or subscribe/register.
Categories: Basel III, Credit Risk, Risk and RegulationBasel III,Credit Risk,Risk and Regulation, Basel III,Credit Risk,Risk and Regulation, , Capital Markets, Performance Measurementcapital,performance, Capital Markets,Performance Measurement, Keywords:CVA, CCR, Financial Crisis, CDS, Derivatives CVA, CCR, Financial Crisis, CDS, Derivatives
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