Risk Management in Trading: Techniques to Drive Profitability of Hedge Funds and Trading Desks

CHAPTER 9 Credit Value Adjustments (CVA)

Counterparty credit risk is a specific type of credit risk related to the probability that a counterparty to a financial contract will fail to meet its obligations. This type of credit risk is commonly obtained by signing contracts with other companies or entering into trading agreements. Counterparty credit risk differs from other types of credit risks, like a loan or a lease, because it is bilateral (both sides to the contract depend on the counterparty to meet its obligations) and occurs as a part of doing business.

This chapter discusses techniques that traders use to manage counterparty credit risk. The basic cause of counterparty risk is that trading can’t be done in isolation. Every time someone wants to buy an asset, someone else needs to sell. When trades involve obligations that are not immediately resolved, traders are exposed to the risk that their counterparty will not meet its part of the bargain. As a result, traders depend on their trading partners to meet their trading obligations, and are exposed to the risk that their trading partners will default on their obligations.

In addition to managing risk, financial regulations require traders to calculate expected losses from credit events and adjust the value of their positions accordingly. The adjustments are called credit value adjustments or CVA.

From the perspective of making trading and risk management decisions, credit value adjustments allow traders to control risk ...