Credit Value Adjustment with Market-Implied Recovery

Abstract

We present a model for CVA calculation in which the recovery rate is inferred from the term structure of CDS spreads. The negative relation between recovery rates and default probabilities induces a substantial underestimation of the CVA when constant recovery is assumed. That underestimation prevails for both unilateral and bilateral CVA as well as for the CVA capital charge. It gets more severe as the horizon of the position increases. Our CVA model with market-implied recovery also offers a way to capture correlation effects between the level of exposure and counterparty risk.

Keywords: CVA, Implied recovery, Credit risk, OTC derivatives

JEL Classification: G13, G20