Risk Management and Financial Institutions, 4th Edition

CHAPTER 20 CVA and DVA

As explained in Chapter 18, there are two ways in which over-the-counter derivatives transactions are cleared: through central clearing parties (CCPs) and through bilateral agreements. As a result of regulations introduced since the credit crisis, transactions between financial institutions in standardized derivatives have to be cleared through CCPs. Transactions in nonstandard derivatives between financial institutions are cleared bilaterally, but regulations being introduced will require a great deal of collateral to be posted so that there will be virtually no credit risk. This chapter focuses on bilaterally cleared over-the-counter derivatives transactions that entail credit risk. This includes transactions with non-systemically important end users and transactions with other counterparties that were entered into before the new rules came into effect.

Assessing the credit risk for derivatives transactions is much more complicated than assessing the credit risk for loans because the future exposure (i.e., the amount that could be lost in the event of a default) is not known. If a bank makes a $10 million uncollateralized five-year loan to a client with repayment of principal at the end, the bank knows that its exposure is approximately $10 million at all times during the five-year period. If the bank instead enters into a five-year uncollateralized interest rate swap with the client, the future exposure is much less certain. This is because the future ...