Counterparty Valuation Adjustments

Abstract

Despite the recent market upheavals, the OTC derivatives markets continue to comprise one of the largest components of the financial markets, with an overall outstanding notional of $547 trillion in December 2008, 70% of which are in interest rate derivatives. As of June 2009, this grew to $605 trillion. And in spite of market contractions, gross values in the OTC markets are up. From June 2008 to December 2008, OTC gross market value increased 60%, from $20 trillion to $32 trillion (Bank for International Settlements, June 2009). Interest rate derivatives’ gross market value doubled from $9 trillion to $18 trillion.

Prompted by the desire to weather or even reduce market turmoil, regulations, accounting practices and investment practices have been under reevaluation. In particular, approaches for analyzing and mitigating counterparty risk have garnered renewed interest. Regulators have been advocating greater usage of clearing houses. Accounting boards have been refining and codifying fair market valuation, placing additional emphasis on careful consideration of counterparty risk. The IASB has even issued a request for comment on counterparty risk calculation methodologies. And investors and traders have been trying to better factor some notion of counterparty risk into their trading and risk management practices.

Here we will investigate the notion of counterparty risk and the associated counterparty valuation adjustment (CVA) in the fixed income markets. We will outline the CVA calculation, detail the underlying model assumptions, give examples of the calculation and discuss the impact the CVA has in the value of these instruments.

Keywords: CVA, risk, counterparty risk, credit risk, counterparty risk valuation, interest rate derivatives, CDS, credit default swaps, CCDS, contingent credit default swaps, interest rate swaps, credit crisis, financial crisis, FASB 157, IAS 39

JEL Classification: G12, G13