CREDIT VALUATION ADJUSTMENT
Figure 2: Expected Positive & Negative Exposure Profiles
One of the main challenges to calculate CVA is to design decision-support
tools bringing together the necessary market, portfolio and counterparty data with the right analytics.
CVA Desks for Commodity Trading Firms Traditionally, the management
Source: NQuantX, LLC
We can see the Expected Positive Exposure (EPE) and the Expected Negative Exposure (ENE) profile for a set of nettable contracts with a counterparty in Figure 2. The EPE is used for CVA calculations and represents the expected exposure in the event of a default of our counterparty. The ENE represents the expected exposure in the event of our own firm defaulting. Where PD is probability of default; EPE and ENE are the expected positive
of credit risk at commodity trading firms has been a passive rather than proactive exercise. Many credit risk management policies still approach the decision whether to allow a trader to enter into a deal in a ‘binary’ fashion.
The general rule is that as long as the counterparty credit limits are not breached, traders can continue trading with a given counterparty. The ‘binary’ approach creates a situation where traders are
in charge of ‘managing’ the credit risk of the firm. Energy and commodity traders have expertise in their respective markets, but they are not often credit ‘experts’ so it does not appear to be optimal to transfer the management of credit risk explicitly to those traders. In addition, most risk policies do not have explicit incentives for traders to manage credit risk. As a response to the increased magnitude and complexity
Credit Valuation Adjustment & Debt Valuation Adjustment CVA = PDcpty * EPE * LGDcpty DVA = PDown
and negative exposures respectively, and LGD is the expected Loss Given Default. At the portfolio level, the Net
adjustment to the value of a derivatives book is the difference between the sum of the CVA minus the sum of the DVA.
* ENE * LGDown
of the credit risk dimension in derivatives trading, many firms have developed units and systems to measure, price, and manage counterparty risks. These desks act as specialized units that consolidate counterparty risk management at the firm level and are often known as CVA desks. Setting up a CVA desk represents a change
in credit risk management philosophy and in order to be successful it requires senior
management support, as well as a well designed policies and procedures to support the desk activities. One of the key areas is to define how credit risk will be transferred and priced from individual trading desks to a centralized CVA desk. For example, some CVA desks may charge a fee to the trading
desks as the cost of doing business, and those trading desks pass the fees to the counterparties through the terms in the deals that are conducted.
In some financial institutions, the CVA desk
Setting up a CVA desk represents a change in credit risk management philosophy
The implementation of CVA at the
valuation and risk measurement level introduces other risks such as potentially higher P&L volatility as well as increased model risk arising from CVA errors.
66 December 2010
is structured as a profit centre whose traders attempt to profit from active credit risk bets. For most energy and commodity firms, the starting goal of the CVA desk is likely to be
the active management of credit exposures with an emphasis on hedging and loss minimization. One of the areas that can bring most benefits versus the
traditional approach to manage credit risk is to approach CVA from a portfolio level and the diversification between deals with the same counterparty. CVA at a counterparty level is not the
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