Counterparty Credit Risk- CVA,DVA And FVA
OTC derivatives carry counterparty credit risk unlike exchange-traded products. Adjustments like CVA, DVA, FVA, KVA, and COLVA—collectively XVA—quantify funding, credit, and capital costs, ensuring accurate pricing and risk mitigation post-2008.
What is a CVA, DVA, FVA, and many such adjustments that get part of the pricing of the OTC Derivatives market to mitigate Counterparty Credit Risk? How they have changed with time and basic relevance of each of them, let's understand them . . .
In comparison to Exchange traded market where we have Credit risk mitigated by the Clearing House, the OTC Derivative market has a high Counterparty Credit Risk, 2008 Financial crisis was the best example. Regulators took quite a lot of measures to reduce counterparty credit risk, one of them was the mandatory clearing of vanilla OTC products especially the Interest Rate Swap that comprises of more than 80 % of OTC trading volumes and still working towards moving many other products on it .
In OTC markets, previously there was no formalized way of collateral exchanged to mitigate cpty risk. So there were high chances of default by either of the parties and other parties losing money. So if Party A and Bank B are trading an Interest Rate Swap where Party A has an unrealized profit and Bank B files for bankruptcy and defaults, Party A will have to book a loss. The opposite can…
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