Quantitative Advisory Series

Valuation Adjustment (xVA)

Series #1 - CVA/DVA/FVA

March 2024
Valuation adjustment: CVA/DVA/FVA

IFRS 13 defines fair value as “the price that would be received to sell an asset or
paid to transfer a liability in an orderly transaction between market participants (an
exit price)”. This includes the assumptions other market participants would be
relying on when pricing the asset or liability. One of those assumptions, which turns
out to be complex even for simple transactions, relates to risks, namely credit risk,
funding risk, margin risk, etc. The adjustments for those risks is referred to as xVA.
In this series on xVA, we will highlight the challenges faced by entities when
estimating those risks and trying to calculate the adjustment value.

There are several xVA calculated by market How does it work?

participants. Some of those are only observed in
financial institutions, but the most common ones are:
1. Credit Valuation Adjustment (CVA),
2. Debit Valuation Adjustment (DVA), and
3. Funding Valuation Adjustment (FVA).
CVA and DVA are the opposite of each other. Where
CVA accounts for the counterparty creditworthiness,
DVA accounts for an entity own creditworthiness. In
other words, the risk that one defaults on the other
and doesn’t fulfill its obligation.
FVA accounts for the cost (benefit) of funding an
uncollateralized position. It can be separated in two:
1. Funding Benefit Adjustment (FBA), and
2. Funding Cost Adjustment (FCA).
FCA and DVA are closely related, but that’s for later.
Other xVA are also considered. For example, the
Margin VA which factors in the cost of funding the
initial margin. Another example, the Collateral VA
which is similar to FVA but for collateralized
positions. A new one gaining market interest is CO2e
VA that aims at capturing the impact of financing
operations in CO2 emitting entities.
Derivative valuation is usually performed under
risk-neutral conditions, or simply said, risk-free.
However, that doesn’t always hold true. A great
reminder of that was the fall of Lehman Brothers
and the subsequent 2008 financial crisis. So how
do you adjust the risk-free valuation to factor in the
risk of losses due to creditworthiness?
For example, a bank enters into a derivative with a
counterparty. Two things need to be considered:
1. The exposure represents how much will be
owed by either sides at any given point during
the life of the derivative based on the market
conditions at that point, realized or expected.
2. The probability of default represents the
likelihood that the counterparty default on
the above exposure. This may also be
dependent on market conditions.
The bank is likely to make a larger adjustment if its
counterparty has 20% chance of defaulting on its
+1m$ exposure in three months than when the
chances drop to 0.2%.
These are the components that need to be
considered in order to go from a risk-free valuation
to a risk-adjusted valuation.

1 Quantitative Advisory Series

Valuation adjustment: CVA/DVA/FVA
The CVA covers the risk of the counterparty
defaulting on the bank and the DVA covers the
bank’s own risk of defaulting on the counterparty.
In cases where the derivative is unidirectional
(e.g., an option), either the CVA or the DVA might
be nil as one party will never owe the other.
Another aspect that is not considered under risk-
neutral valuation is funding. A bank needs to fund
its derivative position in order to hedge it with
another (opposite) derivative position. Similar to
how creditworthiness is incorporated in the
valuation, funding costs depend on two things:
1. The exposure, as presented before.
2. The cost at which the bank can raise funds
compared to market risk-free rates, i.e., the
funding spread.
The FVA covers the risk of having to fund a
derivative at a higher costs that market rates.
There is not a single funding spread to estimate,
but most likely two as an asymmetry exists
between borrowing and lending money.
The asymmetry leads to a more detailed split in
the FVA to account for both sides, i.e., the
Funding Benefit Adjustment and the Funding Cost
Adjustment. The FBA is the result of the bank
being able to lend funds in excess of what is
needed to fund a derivative. On the other side,
the FCA is the result of the bank needing to
borrow funds required to fund a derivative. This
distinction is handy when comparing the FVA to
the DVA.
2 Quantitative Advisory Series
Challenge #1
Methodology and resources
xVA not only depend on the current market value
or exposure, but on future expected exposure.
That is often the first challenge faced by market
participants in the estimation of xVA. Generally
spearking xVA take the following form:
𝑇
𝑥𝑉𝐴 = න 𝑔 𝑉 𝑢 , 𝑋(𝑢) 𝑑𝑢
0
Where the function 𝑔 depends on the value of the
position (𝑉) and of the collateral (𝑋) at time 𝑢.
For the xVA under consideration:
• 𝑔𝐶𝑉𝐴 = LGD × max 𝑉 − 𝑋, 0 × 𝑃𝐷𝑐𝑡𝑝𝑦
• 𝑔𝐷𝑉𝐴 = LGD × m𝑖𝑛 𝑉 − 𝑋, 0 × 𝑃𝐷𝑜𝑤𝑛
• 𝑔𝐹𝑉𝐴 = 𝑠𝑓𝑢𝑛𝑑 × (𝑉 − 𝑋)
The market practice is to rely on simulation-based
methods to generate the distribution of future
exposure as a basis for xVA estimation. However,
having the right resources, human or
technological, in-house to perform such
simulation is often expensive and requires
specialized knowledge to be used adequately. It
becomes a matter of cost/benefit to have these
performed by a third party on a regular basis.
The market data required to perform the
calibration, simulation, and calculation also
requires resources. This adds to the costs of
maintaining the in-house infrastructure for a few
calculations every year.
Valuation adjustment: CVA/DVA/FVA

Challenge #2
DVA = FVA?
A frequent question for market participants is
whether calculating both DVA and FVA leads to
double counting. The answer is not straight forward
as it captures different risks. However, a simple use
case can help provide an answer.
In absence of liquidity risk, DVA and FVA will
converge for an OTM portfolio.
This also supports the reason why many financial
institutions choose to calculate only CVA and
FVA, or CVA, DVA and FCA.

Using a portfolio of four pay fixed/receive float Challenge #3

interest rate swaps, here is how CVA, DVA and FVA
Collateral
evolves.
As presented with the previous example, the
Without collateral
impact of collateral can be significant. However, it
MtM CVA DVA FVA is not always simple to factor in. In addition to the
Asset 84,116 7,157 -15,439 future exposure, one has to keep track of
Zero 53, 070 11,377 1,298 thresholds and minimum transfer amounts when
Liability 33,791 18,161 18,392 performing a CVA and DVA calculation. For FVA,
there might be different spreads for funding
(borrowing and lending) and collateral.
With collateral (threshold @ 250k$)
With perfect collateralization
MtM CVA DVA FVA
MtM CVA DVA FVA
Asset 12,372 1,220 -1,967
Asset - - -
Zero 9,276 1,738 -196
Zero - - -
Liability 6,706 2,347 1,564
Liability - - -
First, for an asset portfolio, the DVA might be
relatively small. However, there is still a need to The above table highlights a new challenge with
fund the positive market value leading to a large (near) perfect 1 collateralization – is it true that
FVA, mainly through the funding cost. FVA vanishes? In facts no, it “transforms” into
Collateral Valuation Adjustment (ColVA). This
Second, for a portfolio with no market value, the adjustment accounts for differences between the
FVA tends towards 0 as the funding cost and rate received/paid on the collateral and funding
funding benefit offset over the life of the portfolio. the position at a different rate.
Since DVA only account for negative future
exposure, it will exhibit a larger number. Collateral exchange is considered as variation
margin, but an initial margin often has to be
Finally, for a liability portfolio, FVA is mainly a posted and maintained. Such initial margin will
funding benefit. This is driven by the relationship require funding. That is the topic for Valuation
between the credit spread (pure default risk) and Adjustment (xVA) Series #2.
the funding spread (default risk and liquidity risk).
1 Perfect collateralization only works with a continuous exchange
of collateral and no minimum transfer amount or threshold.
Otherwise, the absence of risk only happens at the moment the
collateral is exchanged.
3 Quantitative Advisory Series
Summary
The calculation of CVA, DVA,
and FVA can quickly become a
challenge for entities of all
sizes.
For corporate entities or
smaller financial institutions,
meeting the requirements of
accounting standards is a
challenge of resources, both
human and technological.
Approximations exist but they
have their own limitations
which should be handled
carefully.
For larger financial institutions,
this is a challenge of accuracy
and completeness. Ensuring,
through a thorough validation
process, there is no double
counting and that collateral is
adequately considered. Also
developing efficient controls to
capture all collateral
agreements and each
counterparty is subject to the
right calculation.
Whether it is to perform such
calculation on an ongoing basis
or to develop and validate
internal models and calculation
engine, EY Quantitative
Advisory Services has a team of
qualified quantitative finance
professionals to support in all
aspects of the xVA process.
Mohammed Mraoua
Partner
mohammed.mraoua@ca.ey.com
+1 514-879-2632
Christophe Meunier Charette
Manager
christophe.meuniercharette@ca.ey.com
+1 514-879-2753
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