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

18.5 Practical Hedging of CVA

We finally discuss the issues in designing a practical CVA hedging strategy. This is important for a number of reasons. Firstly, historically, institutions have dealt with CVA in very different ways from the actuarial approach (where there is no hedging) to the active approach (maximum hedging). Secondly, as discussed in Chapter 16, CVA hedging is far from straightforward, especially due to effects like cross-gamma (Section 16.5.2) and unintended consequences (Section 16.5.4) that potentially lead to spiralling hedging costs. Finally, it is important to note that a CVA desk faces a three-dimensional approach in terms of their role, which is to optimise the following components:

• Actual economic risk. The actual economic risk that an institution faces.
• Accounting PnL The changes in CVA that drive accounting PnL under the relevant accounting rules.
• Regulatory capital The regulatory capital for counterparty risk.

In an ideal world, the above would be perfectly aligned but, in reality, the misalignment can be significant. For example, a US or Canadian bank under US GAAP is required to account for DVA in their PnL but may not necessarily believe that this reflects the real economic risk they face, nor will they receive any capital relief for DVA. A CVA desk hedging interest rate risk will be reducing their economic risk and accounting PnL volatility but actually increasing their regulatory capital requirements under Basel III (Section 17.4.5).

It is therefore ...