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Since the financial crisis of 2008, derivative pricing has undergone significant reform. Pricing factors that were previously regarded by some market participants as insignificant can no longer be ignored, and adjustments relating to discounting, funding and credit have grown in importance.

One significant development is that of the Credit Valuation Adjustment (CVA). CVA reflects an adjustment to the value of a derivative or portfolio due to counterparty credit risk – essentially adjusting the value of the derivative or portfolio to reflect the likelihood of counterparty default. This adjustment is the difference between the value of the derivative portfolio with a risk-free counterparty and the risk-adjusted value of the portfolio and should equal the cost of hedging against counterparty default.

CVA from a corporate perspective

It is now standard market practice for banks to include in their derivative valuation the effect of CVA, but how does this adjustment work from a corporate perspective? In fact, IFRS 13 requires that any material impact of CVA be included in the fair value of derivatives, yet few corporates currently consider this impact when selecting their derivatives counterparties.

It is clear that banking counterparties also comprise default risk - the 2008 bankruptcy of Lehman Brothers serves as a pertinent reminder of this - and that a derivative with a distressed counterparty does not have the same value as one with a more creditworthy counterparty. Quantifying this impact in monetary terms though can be less straightforward. When corporates receive quoted prices from multiple banks, the prices do not make clear the impact for differing bank counterparty creditworthiness, and so an equal price does not necessarily represent equal fair value. In order to compare fair values from multiple counterparties’ prices on a like for like basis, it is necessary to quantify the CVA from the corporate’s perspective on their bank counterparties. This adjustment to the value of the derivative reflects the likelihood of bank default.

A common corporate approach to bank counterparty selection is to define a minimum counterparty credit rating. There is the potential, however, for this to result in an adverse selection bias in the allocation of trades within the banking group should those counterparties with lower ratings within the group appear to offer more competitive pricing. As the Corporate Treasurer does not typically have the tools at hand to quickly compare pricing on a risk-adjusted basis, there may be a tendency for corporates with such policies to build a concentration of derivative exposures with the lower rated counterparties in their group, while inadvertently trading less with the more creditworthy banks in the group.

CVA is an important factor in trade valuation, not just for banks but also for corporates

Determining bank counterparty credit risk

Credit Default Swaps (CDS) are instruments that allow market participants to hedge against default risk. There is a liquid CDS market traded for most large bank counterparties, and thus a market price of counterparty risk can be observed. From this, it is possible to derive market implied default probabilities which, combined with derivative exposure profiles, can be used to quantify the CVA against banks and therefore arrive at a more realistic cost for comparison.

As of 1st March 2019, the 5y CDS levels of the large international banks* varied significantly from 30bp to 153bp, reflecting a wide range of default probabilities. A higher CDS level implies a higher probability of default, with the aforementioned levels implying a range of 5y default probabilities from 0.5 per cent to 2.5 per cent. The important question is how does this translate into pricing?

Conclusions

CVA is an important factor in trade valuation, not just for banks but also for corporates. For this reason, it is not possible for corporates to compare the fair value of quoted prices from multiple counterparties in a way that incorporates credit risk by simply comparing the quoted prices. In the next article in the series, we explore in further detail the methodology behind CVA calculation and identify under which scenarios CVA becomes material and therefore becomes even more important to consider.

*Large international banks refers to the group of banks selected by Bloomberg for the BANK CDS page.


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