Contributor: Dan Travers
Credit Valuation Adjustment (CVA) has become increasingly important in the derivatives trading world since the crisis as a way to price in the cost of counterparty risk. As such, there are an ever increasing number of banks adopting CVA as a core part of their process for managing counterparty credit risk.
This has traditionally been conducted by allowing traders to trade freely up to a hard stop credit limit. However, this approach allows no visibility into how the limit is utilized, or which deals may be causing more counterparty risk than they are actually making in P&L. By enriching the management of counterparty risk with a CVA charge for counterparty deals, trades are charged (or rewarded) for the counterparty risk they incur. The key being that the CVA for each deal is related to the amount of counterparty risk for that specific deal only. In a portfolio of deals, it should be possible for management to see a dollar amount for the total counterparty risk the bank is taking on, as well as for each desk, book or deal. This transparency can drive better management assessment on which areas of the bank are profitable.
Offering this deal-level CVA information to traders allows visibility into how the credit worthiness of the counterparty or the direction of positions with that counterparty may be affecting the profitability of the deal. This information can positively affect the decision making of traders if available pre-deal.