18.2 The Role of a CVA Desk
Not all traders and businesses can become experts in counterparty risk and CVA.2 CVA can be a significant and exotic component of a valuation, as illustrated in Figure 18.1. Here, without CVA the PnL is a simple linear function of the market move, whereas CVA introduces a more complex non-linear behaviour. Due to the potentially complex nature of CVA, there is a need to centralise its management and decentralise the associated PnL from individual trading desks.
Figure 18.1 Illustration of the need for transfer pricing of CVA.
To achieve this, there are two primary needs (Figure 18.2):
- Transfer pricing. Counterparty risk arises very heterogeneously. Short-dated trades, high-quality and collateralised counterparties all lead to relatively small CVAs. On the other hand, long-dated trades, weaker credit quality, uncollateralised counterparties and wrong-way risk give rise to significant CVAs. It is important to charge the correct CVA to each trade, preferably at inception, accounting for important aspects such as up-front payments, yield curve shapes and risk mitigants such as netting and collateral. This correctly accounts for the expected cost of the counterparty risk and incentivises ...