CVA (Credit Valuation Adjustment)
Quantitative Finance glossary · Quantitative Finance
Definition
Market value of bilateral counterparty default risk — the difference between the risk-free price and the price accounting for counterparty default: CVA = (1-R),int_0^T EE(t),dPD(t), where EE(t) is the discounted expected positive exposure, R is recovery, and PD is the risk-neutral default-time distribution (often Poisson with hazard h bootstrapped from CDS quotes). Required by Basel III and IFRS 13. Wrong-way risk arises when exposure EE(t) and counterparty PD are positively correlated (e.g. selling protection on a name correlated with the counterparty).
CVA (Credit Valuation Adjustment) in plain English
CVA is the price tag on the risk that whoever is on the other side of your trade might go bankrupt before paying you what they owe. If deals were risk-free they'd be worth one price, but because your counterparty could default, the deal is worth a bit less — and CVA is exactly that markdown. Roughly, you add up, over the life of the trade, how much they'd owe you at each moment (the 'exposure') times the chance they default around then, scaled by how little you'd recover: CVA = (1-R)int_0^T EE(t),dPD(t). Regulators require banks to calculate this. The nastiest case is 'wrong-way risk' — when a counterparty is most likely to default precisely when they owe you the most, like buying default insurance from a bank that fails in the same crash that triggers the payout.
Learn these first
Related Quantitative Finance terms
Quantitative Finance practice questions · Quantitative Finance flashcards · Quantitative Finance study guide