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

16.6 The Impact of DVA and Collateral

16.6.1 Hedging Bilateral Counterparty Risk

As discussed in Chapter 14, bilateral counterparty risk (BCVA) means that an institution manages CVA under the assumption that they, as well as their counterparty, may default with the “own default” component, commonly known as DVA. This aspect will always reduce the price of counterparty risk as defined by BCVA, since an institution will always “gain” when they default due to being not obliged (“able” would be a better word) to make contractual payments. In Chapter 13, it was suggested that monetisation of DVA was potentially problematic. Now we can look more deeply into this aspect with the hedging implications of DVA.

The first implication of using BCVA is that all calculations are conditioned on an institution's own survival, which reduces the CVA in the first component of equation (13.1). In Section 13.1.2, we argued that this was reasonable since an institution need not consider losses due to their counterparty defaulting in scenarios where they themselves default first. Failure to account properly for this “first to default” component would, therefore, create a double counting effect.²⁶ However, even this aspect is not completely clear when we analyse BCVA on hedging grounds. The obvious hedge for unilateral CVA is to buy CDS protection referencing the counterparty. When BCVA is considered then a more natural hedge would be the same contract that terminates in the event of an institution's own ...