Credit Valuation Adjustment

Pricing Component

Bilateral contracts are priced by subtracting this charge from the risk-free value of the derivative to arrive at a realistic transaction price. When calculating a credit valuation adjustment, valuation desks use the expected exposure profiles, the probability of default, and the expected loss given default for each counterparty. This adjustment is updated daily in response to movements in credit spreads and underlying market variables.

Counterparty Risk

Uncollateralized trades require much higher adjustments than transactions governed by credit support annexes with daily margin exchanges. The credit valuation adjustment increases as the credit quality of the counterparty deteriorates or as the volatility of the underlying derivative contract rises. This risk management framework protects the financial institution from booking unrealized profits that may never be collected if the counterparty defaults.

Hedging Strategy

Trading desks actively manage this credit exposure by purchasing credit default swaps linked to the names of their primary counterparties. To hedge the credit valuation adjustment, a bank sells protection or buys protection to offset the changes in valuation caused by credit spread movements. This dynamic hedging is complex because it requires constant rebalancing of the hedge positions as the derivative value and counterparty risk fluctuate over time.

Financial institutions also use collateral agreements to limit exposure, although residual risk often remains due to the time delay between a counterparty default and the liquidation of the collateral.