Credit Value Adjustment with Market-Implied Recovery
42 Pages Posted: 28 Jun 2016 Last revised: 9 Oct 2017
Date Written: October 6, 2017
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
Suggested Citation: Suggested Citation