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

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16.7 Summary

This chapter has been concerned with a thorough analysis of the hedging aspects of CVA. We have shown that a complete hedging of credit risk and exposure components is complex due to the large number of variables, relative illiquidity of the CDS market, and aspects such as cross-gamma and jump-to-default risk. Sensitivities to spot rates, volatility, correlation, cross-dependency and default have all been described. We have also shown the impact of collateral on hedging and discussed the hedging implications of using bilateral counterparty risk. For an institution to manage their counterparty risk effectively requires a prudent choice of which key variables upon which to focus.

The unintended consequences of CVA hedging have been illustrated. Hedging CVA is a new area and traders may be prone to over-reaction. Markets prone to blowups, due to their structural nature and associated re-hedging effects, cannot be avoided altogether. Many markets experience granular flows due to re-hedging caused when specific thresholds are breached. Sudden thinning of liquidity, volatility increases and gaps cannot be avoided completely. The market may have to bear CVA hedging problems or improve the liquidity, or variety, of credit derivative products for effective risk transfer. However, the sheer complexity of CVA hedging and its cross-asset nature suggest that the question of whether or not to hedge CVA is one that must be considered carefully.

In the next chapters, we explore in ...

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