Counterparty Credit Risk and Credit Value Adjustment: A Continuing Challenge for Global Financial Markets, 2nd Edition

16.1 Background to CVA Hedging

16.1.1 Aim of CVA Hedging

A key aspect of CVA, as discussed in Chapter 12, is the ability to separate the risk-free and risky value of a derivative (or set of netted derivatives). This extends to hedging where the risk-free value¹ and CVA can be hedged separately. A simple example of the aim of CVA hedging is given in Table 16.1, which shows the impact of a market move on the risky and risk-free value, which is also illustrated in Figure 16.1. In this example, the market move causes the risk-free value to increase but the risky value to decrease (due to an increasing CVA). Without hedging the CVA, there would be a net loss on the risky position.

Table 16.1 Numerical illustration of hedging of risky value via the CVA and risk-free MtM.

Figure 16.1 Illustration of the ideal hedging of a risky derivatives position via the risk-free and CVA components. The market move causes an increase in the risk-free value that creates a loss on the corresponding hedging instrument. The CVA, however, increases and therefore the associated hedge produces a gain. Overall, the risky value decreases, which is hedged via an overall gain on the CVA versus a loss on the risk-free hedge.

The above approach implies that different trading desks can be responsible for ...