An X-Value Adjustment (XVA, xVA) is an umbrella term referring to a number of different “valuation adjustments” that banks must make when assessing the value of derivative contracts that they have entered into.[1][2] The purpose of these is twofold: primarily to hedge for possible losses due to other parties' failures to pay amounts due on the derivative contracts; but also to determine (and hedge) the amount of capital required under the bank capital adequacy rules. XVA has led to the creation of specialized desks in many banking institutions to manage XVA exposures.[3][4]

Context

Historically,[5][6][7][8][9] (OTC) derivative pricing has relied on the Black–Scholes risk neutral pricing framework which assumes that funding is available at the risk free rate and that traders can perfectly replicate derivatives so as to fully hedge.[10] This, in turn, assumes that derivatives can be traded without taking on credit risk. During the financial crisis of 2008 many financial institutions failed, leaving their counterparts with claims on derivative contracts that were paid only in part. Therefore it became clear that counterparty credit risk must also be considered in derivatives valuation,[11] and the risk neutral value is to be adjusted correspondingly.

Valuation adjustments

When a derivative's exposure is collateralized, the "fair-value" is computed as before, but using the overnight index swap (OIS) curve for discounting. The OIS is chosen here as it reflects the rate for overnight secured lending between banks, and is thus considered a good indicator of the interbank credit markets.

When the exposure is not collateralized then a credit valuation adjustment, or CVA, is subtracted from this value [5] (the logic: an institution insists on paying less for the option, knowing that the counterparty may default on its unrealized gain). This CVA is the discounted risk-neutral expectation value of the loss expected due to the counterparty not paying in accordance with the contractual terms, and is typically calculated under a simulation framework;[12] [13] see Credit valuation adjustment § Calculation.

When transactions are governed by a master agreement that includes netting-off of contract exposures, then the expected loss from a default depends on the net exposure of the whole portfolio of derivative trades outstanding under the agreement rather than being calculated on a transaction-by-transaction basis. The CVA (and xVA) applied to a new transaction should be the incremental effect of the new transaction on the portfolio CVA.[12]

While the CVA reflects the market value of counterparty credit risk, additional Valuation Adjustments for debit, funding cost, regulatory capital and margin may similarly be added.[14][15] As with CVA, these results are modeled via simulation as a function of the risk-neutral expectation of (a) the values of the underlying instrument and the relevant market values, and (b) the creditworthiness of the counterparty. This approach relies on an extension of the economic arguments underlying standard derivatives valuation.[13]

These XVA include the following;[13][16] and will require [17] careful and correct aggregation to avoid double counting:

Other adjustments are also sometimes made including [13] TVA, for tax, and RVA, for replacement of the derivative on downgrade.[14] FVA may be decomposed into FCA for receivables and FBA for payables - where FCA is due to self-funded borrowing spread over Libor, and FBA due to self funded lending. Relatedly, LVA represents the specific liquidity adjustment, while CollVA is the value of the optionality embedded in a CSA to post collateral in different currencies. CRA, the collateral rate adjustment, reflects the present value of the expected excess of net interest paid on cash collateral over the net interest that would be paid if the interest rate equaled the risk-free rate.

Accounting impact

See also: Credit valuation adjustment § Function of the CVA desk

Per the IFRS 13 accounting standard, fair value is defined as "the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date."[21] Accounting rules thus mandate [22] the inclusion of CVA, and DVA, in Mark-to-market accounting.

One notable impact of this standard, is that bank earnings are subject to XVA volatility, [22] (largely) a function of changing counterparty credit risk. A major task of the XVA-desk, therefore,[4] is to hedge[13] this exposure; see Financial risk management § Banking. This is achieved by buying, for example, credit default swaps: this "CDS protection" applies in that its value is driven, also, by the counterparty's credit worthiness. [23] Hedges can also counter the variability of the exposure component of CVA risk, offsetting PFE at a given quantile.

Under Basel III banks are required to hold specific regulatory capital on the net CVA-risk. [24] (To distinguish: this charge for CVA addresses the potential mark-to-market loss, while the SA-CCR framework addresses counterparty risk itself.[25]) Two approaches are available for calculating the CVA required-capital: the standardised approach (SA-CVA) and the basic approach (BA-CVA). Banks must use BA-CVA unless they receive approval from their relevant supervisory authority to use SA-CVA.

The XVA-desk is then responsible for managing counterparty risk as well as (minimizing) the capital requirements under Basel.[26] The requirements of the XVA-desk differ from those of the Risk Control group and it is not uncommon to see institutions use different systems for risk exposure management on one hand, and XVA pricing and hedging on the other, with the desk employing its own quants.

References

  1. ^ "X-Value Adjustment". Association of Corporate Treasurers.
  2. ^ "Valuation adjustments and their impact on the banking sector" (PDF). PricewaterhouseCoopers. December 2015.
  3. ^ "CVA traders left stranded as XVA becomes big new acroynm". eFinancialCareers. 2014-06-20. Retrieved 2023-09-27.
  4. ^ a b International Association of Credit Portfolio Managers (2018). "The Evolution of XVA Desk Management"
  5. ^ a b Derivatives Pricing after the 2007-2008 Crisis: How the Crisis Changed the Pricing Approach, Didier Kouokap Youmbi, Bank of EnglandPrudential Regulation Authority
  6. ^ XVAs: Funding, Credit, Debit & Capital in pricing. Massimo Morini, Banca IMI
  7. ^ Brigo, Damiano (November 2015), Nonlinear valuation and XVA under credit risk, collateral margins and Funding Costs (PDF), Université catholique de Louvain, [Course notes: Doctoral course, Université catholique de Louvain, 19-20 Nov 2015]((citation)): CS1 maint: location missing publisher (link)
  8. ^ Claudio Albanese, Simone Caenazzo and Stephane Crepey (2016). Capital Valuation Adjustment and Funding Valuation Adjustment. Risk Magazine, May 2016.
  9. ^ Brigo, Damiano (November 5, 2011). "Counterparty Risk FAQ: Credit VaR, PFE, CVA, DVA, Closeout, Netting, Collateral, Re-hypothecation, WWR, Basel, Funding, CCDS and Margin Lending" (PDF). Department of Mathematics, King's College, London. arXiv:1111.1331.
  10. ^ See Black–Scholes equation § Derivation of the Black–Scholes PDE; Rational pricing § The replicating portfolio
  11. ^ Kjølhede, Christian; Bech, Anders. "Post-Crisis Pricing of Swaps using xVAs" (PDF). Aarhus University.
  12. ^ a b John Hull (May 3, 2016). "Valuation Adjustments 1". fincad.com.
  13. ^ a b c d e John C. Hull and Alan White (2014). Collateral and Credit Issues in Derivatives Pricing. Rotman School of Management Working Paper No. 2212953
  14. ^ a b XVA and Collateral: pricing and managing new liquidity risks. Andrew Green
  15. ^ XVA: About CVA, DVA, FVA and Other Market Adjustments, Discussion paper: Louis Bachelier Finance and Sustainable Growth Labex. Stephane Crepey
  16. ^ "XVAs Defined: The Profitability Puzzle". www.numerix.com.
  17. ^ "Xva PDF | PDF | Hedge (Finance) | Arbitrage". Scribd. Retrieved 2023-09-25.
  18. ^ "CVA, DVA And Hedging Earnings Volatility | Quantifi". www.quantifisolutions.com. Retrieved 2023-08-24.
  19. ^ "Funding Valuation Adjustment (FVA), Part 1: A Primer | Quantifi". 2014-03-20.
  20. ^ Basel Committee on Banking Supervision; Board of the International Organization of Securities Commissions (March 2015), Margin requirements for non-centrally cleared derivatives, Basel: Bank for International Settlements (BIS), ISBN 978-92-9197-063-6
  21. ^ "IFRS 13.9 and IFRS 13 Defined Terms". ifrs.org.
  22. ^ a b Ernst & Young (2014). Credit valuation adjustments for derivative contracts
  23. ^ "Components of CVA Hedging"; §16.2 in John Gregory (2014). "Counterparty Credit Risk and Credit Value Adjustment: A Continuing Challenge for Global Financial Markets", 2nd Edition. Wiley. ISBN 9781118316672
  24. ^ Bank for International Settlements (2020). MAR 50 - Credit valuation adjustment framework
  25. ^ Bank for International Settlements (2018). Counterparty credit risk in Basel III - Executive Summary
  26. ^ Kenneth Kapner and Charles Gates (2016). "The Long and Short of It: An Overview of XVA". GFMI

Bibliography