Counterparty Valuation Adjustments by Bloomberg

Counterparty Counterparty
Valuation Valuation
Adjustments Adjustments
Harvey Stein Harvey Stein

Outline
Markets and Markets and
risks risks
1 Markets and risks
Counterparty
risk
Counterparty Valuation Adjustments Counterparty
risk
CVA and CCDS CVA and CCDS 2 Counterparty risk

Portfolio Portfolio
counterparty risk counterparty risk
Harvey Stein
Accounting Accounting 3 CVA and CCDS
considerations hjstein@bloomberg.net considerations
Summary Summary
References References 4 Portfolio counterparty risk

MD, Counterparty and Credit Risk
Bloomberg LP
5 Accounting considerations
6 Summary
March 2010
7 References
Header: /bb/cvs/repo/devcvs/FIR/TREQ/Risk/CVA/cva-body.latex.tex,v 1.14a 2010/03/05 20:52:51 hjstein Exp
1 / 52 2 / 52
Valuation Valuation
Harvey Stein
Need for CVA Harvey Stein
Size
risks risks
Despite the financial crisis, the OTC derivatives markets continue to
risk risk
be a big part of the market, and interest rate derivatives are the
CVA and CCDS CVA and CCDS
largest part of the OTC derivatives market.
Portfolio We live in an increasingly risky world. Portfolio
• OTC derivatives notional outstanding
Accounting
considerations
• Bank failures. Accounting
considerations
• $547 trillion in December 2008
Summary • Global recession. Summary
• 70% in interest rate derivatives
References References
• Libor rates far from the “risk free” rate. • $605 trillion in June 2009
• OTC derivatives gross market value
A year ago, swaps traded without counterparty risk being taken into • June 2008 — $20 trillion
account. Today, the counterparty could be a low quality bank. • December 2008 — $32 trillion — up 60%
• IRD gross market value
• June 2008 — $9 trillion
• December 2008 — $18 trillion — doubled in 6 months.
3 / 52 4 / 52
Valuation Valuation
Harvey Stein
Demand Harvey Stein
Counterparty risk
risks risks
risk risk

There is much demand for managing counterparty risk
Portfolio Portfolio
Accounting • Accounting standards — FASB 157 (now “Topic 820, Section Accounting
considerations considerations
10”) and IAS 39 — credit risk must be taken into account. Counterparty risk — the exposure to loss due to a specific
Summary Summary
References
• Regulators. References
counterparty failing to meet contractual obligations, i.e. defaulting.
• Risk managers.
The IASB even issued a request for comment on counterparty risk

calculation methodologies.
5 / 52 6 / 52
Valuation Valuation
Harvey Stein
Bond counterparty risk Harvey Stein
Swap counterparty risk
risks risks
Counterparty Example — Investor is long a bond. Counterparty

risk risk
CVA and CCDS • Counterparty is issuer. CVA and CCDS

Example — Investor enters into a swap.
Portfolio
counterparty risk • Issuer defaults — investor loses bond cashflows, but gets Portfolio
counterparty risk
• Counterparty is the entity with which the swap was transacted.
Accounting recovery on the bond. Accounting • Investor is simultaneously long one leg of the swap, and short the
Summary
• Recovery is a percentage of the principal of the bond. Summary
other leg.
References • Default causes loss of interest payments, and early (but partial) References • Counterparty defaults — investor loses swap cashflows, but gets
return of principal. recovery on the swap.
• Could be an improvement if bond is trading at a sufficient • Recovery is a percentage of the market value of the swap.
discount. • If swap value is positive then there’s a loss.
Example — Investor is short a bond. • If swap value is negative, then there is no loss.
• No counterparty risk.
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Valuation Valuation
Harvey Stein
Risk modifications Harvey Stein
Risk modifications
risks Netting agreements: risks
risk • Optional part of the ISDA master agreement. risk

• In the event of default, recovery is on the net market value of all Collateralization
Portfolio Portfolio
counterparty risk contracts covered by the agreement. counterparty risk
Accounting Accounting • ISDA credit support annex (CSA).

considerations
No netting agreement: considerations
• At the end of the period (day, week, etc), if swap value exceeds a
Summary Summary
References • Investor owns two 5 year 5% swaps to counterparty — one is pay References
threshold, collateral must be posted.
fixed, the other is receive fixed. • Exposure is to the threshold plus the movement of the market
• No net market exposure — the two positions cancel out. value over the period.
• Substantial counterparty exposure: With collateralization, counterparty risk is pretty minimal.
• Get recovery on the market value of the positive swap
• Still owe full value on the market value of the negative swap
With netting agreements, exposure at any given time is on the net

market value of all securities covered. Risk is reduced.
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Valuation Valuation
Harvey Stein
Counterparty Valuation Harvey Stein
Counterparty risk — long only vs
Markets and Adjustments Markets and long/short
risks risks
risk risk
Portfolio Portfolio
Counterparty risk calculations are far more complicated for
counterparty risk counterparty risk instruments that are a combination of long/short positions than for
Accounting
considerations
How does the counterparty exposure and the risk of default impact Accounting
considerations
long only instruments.
Summary
the value of the security? Summary
• In a long only instrument, (like a bond position), counterparty
• The Credit Valuation Adjustment (CVA) is the cost of the risk can be judged by using models that can incorporate a
potential loss. discount curve shift.
• Risk free price - CVA = price of risky security. • In a long/short instrument, (like a swap position), the instrument
can potentially be an asset or a liability. When it’s an asset,
default results in a loss. When it’s a liability, default results in no
change.
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Valuation Valuation
Harvey Stein
Bond counterparty risk Harvey Stein
Equivalent par curve
risks
If a bond with a coupon of C pays f times per year at times ti , with risks
risk maturity tn , the value of the bond is: risk
CVA and CCDS

X
n Z tn
CVA and CCDS To get a feel for the impact of credit spreads on bond values, we can
Portfolio C Portfolio
compute the par curve for the risky bond. For ti = i/f , and for each
counterparty risk D(ti )S(ti ) + 100D(tn )S(tn ) + 100RD(t)P(t)dt, counterparty risk
Accounting
f Accounting n, solve for C (tn ) such that
Summary Summary X
n Z tn
C (tn )
References • P(t) — default probability density function. References 100 = D(ti )S(ti ) + 100D(tn )S(tn ) + 100RD(t)P(t)dt,
Rt f
• S(t) = 1 − P(s)ds — survival probability for time t (the
probability of no default before time t). Then C (tn ) is the implied par curve — the coupons that the issuer
with this CDS spread curve would theoretically use to issue debt at
• R — bond recovery rate.
par.
• D(t) — risk free discount factor for time t.
This is the standard CDS model applied to a fixed coupon bond.

Note that it assumes independence of rates and default.
13 / 52 14 / 52
Valuation Valuation
Harvey Stein
Equivalent par curve example Harvey Stein
Recovery rate impact
On the Bloomberg terminal, we do this calculation in YASN - the Flat curves and equal recovery rates give an equivalent par curve
risks structured notes calculation screen. risks roughly equal to the swap curve shifted by the CDS spreads.
risk risk Otherwise, there can be significant differences, as we see here for a
CVA and CCDS CVA and CCDS flat 100bp CDS curve and a flat 3% swap curve.
Portfolio Portfolio
Accounting Accounting
CDS recovery 0% 40% 80% 40%
Bond recovery 0% 40% 80% 0%
Summary Summary
Term
1 Wk 4.2216 4.2241 4.2366 5.0783
1 Mo 4.0041 4.0071 4.0223 4.7141
6 Mo 3.9861 3.9948 4.0385 4.6741
1 Yr 4.0206 4.0361 4.1144 4.7196
2 Yr 4.0333 4.0420 4.0857 4.7252
3 Yr 4.0333 4.0419 4.0855 4.7251
5 Yr 4.0322 4.0408 4.0845 4.7233
7 Yr 4.0321 4.0407 4.0843 4.7231
10 Yr 4.0316 4.0403 4.0839 4.7223
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Valuation Valuation
Harvey Stein
Par curves vs default probabilities Harvey Stein
Par curves vs default probabilities
Once the risky par curve is computed, one is tempted to strip it and
risks use it for discounting. risks
Counterparty
risk
Good points: Counterparty
risk Using the risky par curve directly for calculations also has drawbacks.
CVA and CCDS • This is simple, straight forward, and in line with common CVA and CCDS
• For nonzero recovery rates, prices produced by this method on
Portfolio
practices. Portfolio
non-par bonds will differ from the default based method.
Accounting • This will properly price par bonds back to par. Accounting
• If the bond recovery rate is zero, this properly prices all bonds! There is a difference between the two methods when the bond is a
Summary Summary
couple of hundred basis points away from par (roughly 5 to 15 basis
References In the zero recovery rate case, this makes the risky discount factors References
points for a 100 bp CDS spread), but given other general
D(ti )S(ti ), uncertainties (such as the recovery rate, or the spread between bonds
and CDS), this is a reasonable margin of error, and can be folded into
so the risky spot rate curve R̄ is given by OAS adjustments.
R̄(ti ) = − log(D(ti )S(ti ))/ti = R(ti ) − log(S(ti ))/ti , Bottom line — adding a spread to the risk free curve is a reasonable
way to price risky bonds.
where R is the risk free rate. So, the survival probabilities add a
spread of − log(S(ti ))/ti (the average hazard rate) to the risk free
rate. This spread is roughly the CDS spread, adjusted by the CDS
recovery rate.
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Valuation Valuation
Harvey Stein
Par curves and OAS Harvey Stein
Advanced risky bond calculations
Once we have a risky par curve, we can use it to apply risky spreads
risks risks on top of a risk free interest rate derivatives models to analyze risky
Counterparty
risk
Counterparty
risk
bonds with embedded options:
Portfolio Portfolio
Accounting If the spread curve is flat, it roughly amounts to a shift of the par Accounting
Summary
curve, which is roughly adding an OAS. Summary
References Using the risky par curve in such a calculation is an improvement, in References
that it factors in the shape of the CDS spread curve.
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Valuation Valuation
Harvey Stein
Counterparty risk in swaps — Harvey Stein
Counterparty risk in swaps —
Markets and Characteristics Markets and Valuation
risks risks
risk Consider a five year swap in a flat interest rate environment. risk Let V (t) be the value of the risk-free swap at time t, and let R be
CVA and CCDS
There is volatility dependent risk: CVA and CCDS the recovery rate on the underlying swap.
Portfolio Portfolio
counterparty risk counterparty risk If the counterparty defaults at time t, the payoff for holding the swap
• Zero volatility:
Accounting Accounting is:
considerations • Swap is always nearly zero market value. considerations
Summary • Minimal default risk. Summary

• If V (t) > 0 we get R × V (t).
• High volatility: • If V (t) < 0 we still owe V (t).
• Swap value in future can be substantial.
• Potentially substantial loss upon default. The above payoff is
There is curve dependent risk: R max(V (t), 0) + min(V (t), 0)

• In a steep interest rate environment, the swap is expected to be = V (t) − (1 − R) max(V (t), 0)
heavily off the money for the duration of its life.
The quantity max(V (t), 0) is the payoff of a swaption maturing at
• Far more counterparty risk. time t on the remainder of the swap.
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Valuation Valuation
Harvey Stein
CVA subtleties
Markets and Valuation Markets and
risks risks
The loss at default time is: CVA valuation can be a little subtle. The swaption to enter into the
risk risk tail of the swap is slightly different from the usual swaption to enter
CVA and CCDS
(1 − R) max(V (t), 0) CVA and CCDS into a swap.
Portfolio
counterparty risk Since this is (1 − R) times the payoff of the swaption maturing at Portfolio
counterparty risk Swap cashflows:
Accounting time t, if we assume independence of rates and default, then the Accounting
current value of the loss conditional on default at time t is:
Summary Summary
Floating Cashflows
References (1 − R)S(t) References
where S(t) is the current value of a swaption to enter into the

Time
remainder of the swap at time t. Summing over the possible default
times weighted by the default probabilities gives us the CVA Fixed Cashflows
adjustment (the difference between the value of the swap to a riskless
counterparty and the risky counterparty) as:
Z
CVA = (1 − R)S(t)P(t)dt
where P is the default probability density.

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Valuation Valuation
Harvey Stein
CVA subtleties Harvey Stein
CVA subtleties
The difference between the value of the forward start swap and the
Markets and
risks
When exercising a swaption to enter into a swap with an odd first Markets and
risks corresponding tail of the underlying swap will typically be substantial,
Counterparty
coupon, the first coupon is adjusted — the floating leg references a Counterparty as is illustrated in the following graph of the two for a 5 year at the
risk shortened index, and the fixed leg only accrues over the remainder of risk
money payer swap, on a 1 million notional in a rising interest rate
CVA and CCDS
the period. CVA and CCDS
environment.
Portfolio Portfolio
counterparty risk
However, in the event of default at that time, the full cashflows are counterparty risk
Accounting
considerations lost. Accounting
considerations

Summary Summary
Floating Cashflows

Exercise Time

Fixed Cashflows

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Valuation Valuation
Harvey Stein
Forward swap rates Harvey Stein
Tail swap rate
The tail of the existing swap is slightly different. Its cashflows and
Markets and
risks
Consider the pay fixed swap with fixed rate F that the holder of a Markets and
risks accruals are the same as for the forward swap, except for the first
Counterparty
swaption would receive on exercise (at time t). Counterparty period, where the reset date (t̄1 ) is earlier than the valuation time t,
risk risk
CVA and CCDS

Let the underlying floating (fixed) leg pay at times ti (ti′ ). Then the CVA and CCDS
and the accrual factors correspond to the full period rather than the
Portfolio time t value of the swap is1 Portfolio partial period. The time t value of the first floating cashflow is
counterparty risk X X counterparty risk
Accounting S(t) = L(t, ti , ti+1 )Z (t, ti+1 )αi − F αi′ Z (t, ti′ ), Accounting Z (t, t2 )
considerations
Since t ≤ t1 ,
considerations − Z (t, t2 ),
Summary Summary Z (t̄1 , t2 )
References L(t, ti , ti+1 ) = (1/αi′′ )(Z (t, ti )/Z (t, ti+1 ) − 1) References
so the value of the tail is
(with Libor accrual factor αi′′ ), so if we assume αi = αi′′ , then S(t)
can be written in terms of Z as: Z (t, t2 ) X
X S̄(t) = − Z (t, t2 ) + L(t, ti , ti+1 )Z (t, ti+1 )αi
S(t) = Z (t, t1 ) − Z (t, tn ) − F αi′ Z (t, ti′ ), Z (t̄1 , t2 ) 2
This gives us the standard expression for the time t value of a forward X
−F ᾱ1′ Z (t, t1 ) − F αi′ Z (t, ti′ )
start swap.
2
1 L(w , x, y ) is the time w forward Libor rate setting at time x and paying at Z (t, t2 ) X
time y , Z (x, y ) be the time x price of a zero coupon bond paying at time y , and
= − Z (t, tn ) − F ᾱ1′ Z (t, t1 ) − F αi′ Z (t, ti′ ).
Z (t̄1 , t2 ) 2
αi (α′i ) are the accrual fractions for floating (fixed) payment periods ti to ti+1 (ti′
′ ), respectively.
to ti+1
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Valuation Valuation
Harvey Stein
Forward swaps and tail swaps Harvey Stein
Forward swap vs tail
compared Under the equivalent martingale measure with respect to numeraire
risks risks N, the time zero value of the forward start swaption is
risk risk N(0)E0 [max(S(t), 0)/N(t)]
Portfolio Portfolio
Instead of this, we need the value of the option on the tail of the
counterparty risk counterparty risk swap. Concentrating on the payoff, if
Accounting The difference between the values of the two is Accounting
considerations considerations Z (t, t2 )
D = S̄(t) − S(t) = − Z (t, t1 ) − F (ᾱ1′ − α1′ )Z (t, t1 )
Summary
Z (t, t2 ) Summary
Z (t̄1 , t2 )
References S̄(t) − S(t) = − Z (t, t1 ) − F (ᾱ1′ − α1′ )Z (t, t1 ). References
Z (t̄1 , t2 ) we have
This is the adjustment that needs to be made to convert the swaption max(S̄(t), 0) = max(S(t) + D, 0) = max(S(t), −D) + D
payoff to the payoff of the option on the tail swap. So the option to enter into the tail of the swap is the same as the
option to enter into the swaption with an associated fee of
S(t) − S̄(t) with an additional cash component of S̄(t) − S(t).
One could apply a convexity adjustment technique to work this out,
but it replacing Z (t, t1 ) and Z (t, t̄1 ) with their corresponding time
zero forward values is a reasonable approximation and it makes these
adjustments fixed values and thus easily handled.
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Valuation Valuation
Harvey Stein
Visualizing counterparty risk
Markets and CVA<Go> Markets and
The calculation and risks can be better visualized by exposure graphs
risks
On the Bloomberg, the CVA function does this calculation.
risks over time:
risk risk
Portfolio Portfolio
Summary Summary
31 / 52 32 / 52
Valuation Valuation
Harvey Stein
CCDS Harvey Stein
CCDS and CVA
Markets and Markets and Consider a CCDS contract on an interest rate swap.
risks Contingent credit default swaps are a variant of credit default swaps. risks
Counterparty
risk With both CDS and CCDS, the buyer of insurance pays the spread
Counterparty
risk
• The payoff of the floating leg of the CCDS contract is the loss
CVA and CCDS until default or maturity (whichever comes first), and receives (1 − R) CVA and CCDS
given default for the interest rate swap.
Portfolio of something at default time. Portfolio • The value of the floating leg is then the CVA value.
Accounting What makes the two contracts substantially different is what exactly Accounting • The fixed leg of the CCDS contract must then be the annuitized
is being made whole. (to default time) value of the CVA.
Summary Summary
References
• CDS — Receives (1 − R) on the principal of a reference security.
References
The CCDS contract is thus the perfect hedge for the counterparty
exposure on the interest rate swap, except that
• CCDS — Receives (1 − R) on the value of a reference security.
• CCDS contracts are thought to be expensive forms in which to
With a CDS contract, the only uncertainty regarding the former’s buy this protection.
payout given default is the recovery rate, because recovery is on a
• CCDS contracts have counterparty risk too!
fixed principal amount.
With a CCDS contract, there is uncertainty on the value on which Any hedge that would be used for the counterparty risk in a swap can
recovery is applied as well. be adjusted to serve as the replicating strategy for the CCDS contract
(except for the counterparty exposure of the CCDS).
33 / 52 34 / 52
Valuation Valuation
Harvey Stein
Hedging issues Harvey Stein
Portfolio counterparty risk
risks risks
risk Hedging counterparty risk can be difficult. The natural hedge: risk

• Take on a position in CDS that neutralizes exposure to credit In the presence of netting agreements, the counterparty exposure
Portfolio Portfolio
counterparty risk moves. counterparty risk
must be computed on the portfolio of securities covered by the
considerations • This locks in the value of the CVA. considerations netting agreement.
Summary Summary
References
But, References
• Loss given default is no longer the sum of the losses in the
individual positions.
• Dynamically hedging with CDS can be expensive.
• Loss given default is (1 − R) of the payoff of a call on the
• Where can you get a risk free swap?
underlying portfolio.
• What about the CVA of the CDS for that matter?
• How do you neutralize credit exposure and default exposure at
the same time?
35 / 52 36 / 52
Valuation Valuation
Harvey Stein
Calculating portfolio counterparty Harvey Stein
Calculating portfolio counterparty
Markets and risk Markets and risk
risks risks
risk risk

Brigo and Massimo take the latter approach.
Portfolio Portfolio
counterparty risk Calculation options: counterparty risk
• Net all of the interest rate swaps covered by a given netting
considerations
• Feed call options on the portfolio to your defaultable interest rate considerations agreement.
Summary Summary
derivatives valuation system. • The floating “leg” of the portfolio is now some sort of amortizing
• Compute value of appropriate call options on the portfolio via floating leg with time dependent leverage.
your interest rate derivatives valuation system, and proceed as • The fixed “leg” is now some sort of amortizing step coupon fixed
above. leg.
• Make some assumptions and get formulas. Difficulties ensue because the leverage could be positive or negative
(i.e. - at some times the aggregate can be a payer swap while at
other times it can be a receiver swap).
37 / 52 38 / 52
Valuation Valuation
Harvey Stein
Portfolio woes Harvey Stein
Accounting considerations
risks risks
risk risk
CVA and CCDS

Consider a portfolio consisting of an at the money 5 year payer swap CVA and CCDS
with fixed rate F1 , and an at the money 3 year receiver swap with Accounting for counterparty risk is required by accounting standards
Portfolio Portfolio
counterparty risk
fixed rate F2 . counterparty risk FASB 157 (US) and IAS 39 (Europe).
considerations considerations FASB 157, Appendix B, Paragraph 5:
Summary
• Credit exposure 1 year out is to the difference between the value Summary
of the two tails being positive. • B5. Risk-averse market participants generally seek compensation
for bearing the uncertainty inherent in the cash flows of an asset
• Similar to the difference between the 4 year swap rate and the 2
or liability (risk premium). A fair value measurement should
year swap rate.
include a risk premium reflecting the amount market participants
The portfolio behaves roughly like a spread between two rates, so the would demand because of the risk (uncertainty) in the cash flows.
credit exposure is like a spread option, and thus, difficult to price.
39 / 52 40 / 52
Valuation Valuation
Harvey Stein
Accounting considerations Harvey Stein
Shifty calculations
One alternative is the discount shift method. The CVA is calculated
risks risks
by shifting the discount curve by the credit spread (like in the bond
Counterparty Accounting rules are currently being updated and globalized. Counterparty
approach).
risk risk
CVA and CCDS Topic 820, Section 10 replaces FASB 157, but it strengthens the CVA and CCDS
When all of the swaptions are in the money, this is the zero volatility
Portfolio position that credit risk must be accounted for: Portfolio
version of the CVA. For a 5 year 5% receiver swap, ignoring volatility
Accounting • 55-8. A fair value measurement should include a risk premium Accounting can lead to errors of 15% to 20%.
Summary reflecting the amount market participants would demand because Summary
References of the risk (uncertainty) in the cash flows. Otherwise, the References Table: 5% 5 year receiver swap, 10 million notional, with market data
measurement would not faithfully represent fair value. In some yielding swap rate of 3.16%
cases, determining the appropriate risk premium might be
difficult. However, the degree of difficulty alone is not a sufficient CDS rate CVA Discount Shift
basis on which to exclude a risk adjustment. 0 0 0
100 17,610 15,227
While accurate valuation of the embedded default risk is preferred, a
200 35,751 29,970
number of alternative approaches have traditionally been accepted.
300 52,950 44,249
400 69,181 58,085
41 / 52 42 / 52
Valuation Valuation
Harvey Stein
Shifty calculations Harvey Stein
Shifty calculations
The errors from the shift approximation are illustrated by the results
risks on an at the money swap. risks
To address the problem of swaps that are a liability, the discount
risk risk method is modified.
CVA and CCDS
Table: At the money 5 year receiver swap, 10 million notional, with market CVA and CCDS
Portfolio
data Portfolio
• Positions of positive value:
CDS rate CVA Discount Shift • Treat as assets.
considerations considerations • Reduce value according to counterparty risk (by discount curve
0 0 0
Summary Summary shift).
References
100 11,852 7,348 References
200 22,870 14,316 • Positions of negative value:
300 33,108 20,923 • Treat as liabilities.
400 42,620 27,189 • Increase value (reduce liability) according to investor’s credit!
In general: Nicely symmetric and based on the theory that the money is owed to
• Errors grow as relevant swaptions go out of the money. the counterparty and only a fraction of it will be paid if the investor
• Large errors when swaptions are close to the money (so that defaults.
volatility plays a large part). But adds problems of bilateral CVA.
• Cannot be used for out of the money swaps — CVA is negative.
• Same typically holds for pay fixed swaps.
43 / 52 44 / 52
Valuation Valuation
Harvey Stein
Net current exposure Harvey Stein
Net current exposure
risks risks
Counterparty
Another approach — the current net exposure method. Counterparty The appeal of the net current exposure method lies largely in its ease
risk risk

of implementation.
• Net current exposure = value at immediate risk of default to
Portfolio Portfolio
• If you can value the positions and get the CDS spreads, you can
counterparty risk investor = max(current market value, 0). counterparty risk
Accounting Accounting easily compute the CVA.

considerations • Cost of the risk of immediate default = cost of insuring against considerations
• Easily extended to portfolios and to take netting agreements into
Summary default via CDS on counterparty’s default. Summary
References References account.

• CDS notional = net current exposure.
• Easily extended to take collateralization into account — reduce
• CDS maturity = some measure of life of deal (maturity or the current net exposure to the threshold level (the level beyond
duration). which the position must be collateralized).
• CVA = Cost of insurance = cost of fixed leg of CDS contract ≈ • Easily extended into a type of bilateral CVA — do as above if
the cost of the CDS spread applied over the life of the CDS position is positive, and do the reverse (impact on counterparty
contract. of one’s own default) if negative.
45 / 52 46 / 52
Valuation Valuation
Harvey Stein
Net current exposure Harvey Stein
Bilateral CVA
The negative of this approach comes from its inaccuracy. Consider
Markets and Markets and In accounting circles, one often finds support for bilateral CVA
risks the CDS position needed to insure the portfolio to maturity. risks
calculations.
risk • Forward value of the portfolio is not constant. risk
• Unilateral CVA — value of contract taking into account default
CVA and CCDS
• Improve hedge by using a portfolio of CDS so that the forward CVA and CCDS
Portfolio Portfolio of counterparty. What we’ve discussed up until now.

counterparty risk market values of the portfolio are matched. counterparty risk
• Bilateral CVA — value of contract taking into account both
Accounting • This CDS portfolio hedges against default risk assuming zero Accounting
considerations
interest rate risk.
considerations
default of counterparty and default of investor.
Summary Summary
References • Current net exposure method is a rough approximation of this References Bilateral CVA is a complicated calculation.
with just one CDS contract.
• Need to know relationship between default of counterparty and
As such, there are a number of disadvantages: default of investor.
• Zero volatility approach, so similar problems to the discount • Often approximated as difference in unilateral CVA of investor
curve shift approach — neglects value from interest rate and counterparty.
volatility, which can be substantial. • Approximation is true bilateral CVA assuming the probability of
• Even less accurate, in that only one CDS contract is used. both parties defaulting before contract maturity is zero.
• Method tends to be unstable — value is proportional to market • Can lead to significant error with high default correlation.
value, which has much higher volatility than the true CVA.
47 / 52 48 / 52
Valuation Valuation
Harvey Stein
Bilateral CVA Harvey Stein
Summary
Markets and
Bilateral CVA is often looked upon favorably. Markets and
• It’s important to factor credit risk into valuations.
risks risks
• Netting agreements and collateralization must be accounted for.
Counterparty • Reduces CVA charge. Counterparty
risk risk • The prices of risky bonds can be calculated based on CDS
• Liabilities behave more like bond liabilities - a drop in credit of
CVA and CCDS CVA and CCDS spreads.
Portfolio the investor will potentially improve the balance sheet. Portfolio
• Bond calculations roughly correspond to just shifting the
Accounting It also has some drawbacks. Accounting discount curve by an appropriate amount.
• Swap credit risk is more complicated because swaps can be
Summary • If investor’s credit is worse than counterparties, bilateral CVA Summary
assets or liabilities, depending on rates.
References
increases value of the derivative above the risk free value! References
• For swaps, the discount curve shift is sometimes used, but it is
• All derivatives (even assets) increase in value when credit rating not very accurate.
drops. • The net current exposure method is used as well, but has similar
• Prices derivative without an associated hedge. shortcomings.
Because of these issues, accounting boards have been lobbied to • Swap credit risk can be calculated using swaptions and CDS
reject bilateral CVA as an acceptable approach. We can hope that rates.
these issues will be addressed as IASB, FASB and other accounting • The CVA is the value of the default leg in a CCDS on the
standards boards work together on global convergence of accounting underlying swap.
standards. • Portfolio CVA calculations are not so easy...
49 / 52 50 / 52
Valuation Valuation
Harvey Stein
References Harvey Stein
References
Markets and
Altman, Kishore; Almost Everything You Wanted to Know About Markets and
risks Recoveries on Defaulted Bonds; Financial Analysts Journal, Nov/Dec risks
Pykhtin, Michael; Zhu, Steven; A Guide to Modelling Counterparty
Counterparty
risk
1996 Counterparty
risk Credit Risk; Global Association of Risk Professionals, Issue 37,
CVA and CCDS Alavian, Shahram; Ding, Jie; Whitehead, Peter; Laudicina, Leonardo; CVA and CCDS July/August 2007
Portfolio
counterparty risk Counterparty Valuation Adjustment (CVA); March 2009 Portfolio
counterparty risk Statement of Financial Accounting Standards No. 157, Fair Value
Accounting
Bank for International Settlements; Detailed Tables on Semiannual Accounting Measurements
Summary OTC Derivatives Statistics at End-June 2009 Summary Stein, Harvey J.; Valuation of Exotic Interest Rate Derivatives -
References
Brigo, Damiano; Masetti, Massimo; A Formula For Interest Rate References Bermudans and Range Accruals, December 7, 2007,
Swap Valuation under Counterparty Risk in presence of Netting http://ssrn.com/abstract=1068985
Agreements; ssrn.com; April 2005 Stein, Harvey J.; Lee, Kin Pong; Counterparty Valuation Adjustments,
Gregory, Jon; Being two-faced over counterparty credit risk, Risk, Recent Advancements in the Theory and Practice of Credit
February 2009 Derivatives, Ed. Tomasz Bielecki, Damiano Brigo, Frédéric Patras,
2010 (to appear)
Cooper, Ian A.; Mello, Antonio S.; The Default Risk of Swaps;
Journal of Finance, Vol. 46, No. 2, June 1991 Topic 820, Fair Value Measurements And Disclosures, Financial
Accounting Standards Board
Jarrow, Robert A.; Yu, Fan; Counterparty Risk and the Pricing of
Defaultable Securities; Journal of Finance, Vol. LVI, No. 6, Oct. 2001
51 / 52 52 / 52

Counterparty Valuation Adjustments by Bloomberg

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Counterparty Counterparty

Harvey Stein Harvey Stein

CVA and CCDS CVA and CCDS 2 Counterparty risk

References References 4 Portfolio counterparty risk

CVA and CCDS CVA and CCDS

The IASB even issued a request for comment on counterparty risk

Counterparty Example — Investor is long a bond. Counterparty

CVA and CCDS • Counterparty is issuer. CVA and CCDS

CVA and CCDS CVA and CCDS

Accounting Accounting • ISDA credit support annex (CSA).

With netting agreements, exposure at any given time is on the net

CVA and CCDS CVA and CCDS

CVA and CCDS

This is the standard CDS model applied to a fixed coupon bond.

that it factors in the shape of the CDS spread curve.

Summary • Minimal default risk. Summary

There is curve dependent risk: R max(V (t), 0) + min(V (t), 0)

where S(t) is the current value of a swaption to enter into the

where P is the default probability density.

Exercise Time 

CVA and CCDS

CVA and CCDS CVA and CCDS

CVA and CCDS CVA and CCDS

CVA and CCDS CVA and CCDS

CVA and CCDS

CVA and CCDS CVA and CCDS

Accounting Accounting easily compute the CVA.

References References account.

Portfolio Portfolio of counterparty. What we’ve discussed up until now.

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