What is Credit Value Adjustment?
Counterpart risk is one of the most critical risks faced by organizations. It is defined as the risk that a counterparty is unable or unwilling to live up to its contractual obligations which are also referred to as counterparty defaults. Within the context of derivatives contracts, default occurs at some point after inception but prior to the end of the contract term. In case of a default, current and future payments required by the contract will not be made.
Now, with reference to the derivative pricing, there is a portion that assumes no counterparty risk and a portion that accounts for counterparty risk. The portion that accounts for counterparty risk is known as the credit value adjustment (CVA). Hence, while conducting trade, the prime objective of the trader is to earn a return greater than the CVA.
Example of Credit Value Adjustment:
The CVA examines counterparty risk at both the trade and counterparty levels. Credit limits, on the other hand, limit exposures at the portfolio level. Thus, the CVA and credit limits complement each other and are often both used to quantify and manage counterparty risk. The CVA aims to minimize the number of counterparties in an effort to maximize netting benefits, while credit limits aim to maximize the number of counterparties in an effort to achieve greater diversification benefits.