Completing CVA and Liquidity: Firm-Level Positions and Collateralized Trades

Abstract

Bilateral CVA as currently implement has the counter-intuitive effect of profiting from one's own widening CDS spreads, i.e. increased risk of default, in practice. The unified picture of CVA and liquidity introduced by Morini & Prampolini 2010 has contributed to understanding this. However, there are two significant omissions for practical implementation that come from the same source, i.e. positions not booked in usual position-keeping systems. The first omission is firm-level positions that change value upon firm default. An example is Goodwill which is a line item on balance sheets and typically written down to zero on default. Another example would be firm Equity. The second omission relates to collateralized positions. When these positions are out of the money in future, which has a positive probability, they will require funding that cannot be secured using the position itself. These contingent future funding positions are usually not booked in any position-keeping system. We show here how to include these two types of positions and thus help to complete the unified picture of CVA and liquidity.

For a particular large complex financial institution that profited $2.5B from spread widening we show that including Goodwill would have resulted in a $4B loss under conservative assumptions. Whilst we cannot make a similar assessment for its collateralized derivative portfolio we calculate both the funding costs and the CVA from own default for a range of swaps and find that CVA was a positive contribution in the examples.

Keywords: CVA, Bilateral CVA, Counterparty Risk, Arbitrage-Free Credit Valuation Adjustment, Interest Rate Swaps, Interest Rate Derivatives, Credit Valuation Adjustment, Bilateral Risk, Credit Spread Volatility, Wrong Way Risk, Goodwill, Equity

JEL Classification: C15, C63, C65, G12, G13