Credit Valuation Adjustment | Basel 2.5

A summary of Credit Valuation Adjustment from the full e-Learning course in Optimal MRM’s catalog.

The short presentation introduces the concept of credit valuation adjustment using components from the corresponding e learning module found under optimal m rms online training service in september 2006 the financial accounting standards board introduced new accounting standards faz 157 to provide guidance on how organizations should arrive at the fair value of

Financial assets and liabilities in financial reporting when faz 157 was introduced the size of the over-the-counter derivatives market in terms of notional amount or face value was approximately 586 trillion dollars almost two-thirds of this amount was comprised of interest rate derivative contracts with the rest comprised of equity effects commodity and other

Types of derivatives by 2013 the size of the over-the-counter derivatives market had grown to 710 trillion dollars to put this in perspective global gdp in 2013 was 73 trillion dollars or 10% of the notional amount of otc derivatives outstanding this comparison is somewhat exaggerated however because unlike straight debt it is the fair or market value of these

Transactions that is at risk of credit default as an indication of counterparty credit exposure the netted market value excluding collateral posted between counterparties averaged three point five trillion dollars from 2009 to 2013 to put into perspective the potential risk associated with this credit exposure excluding collateral it is equal to the amount of

Tier 1 capital broadly defined as common equity and retained earnings minus goodwill held by all large banks in the us the eurozone the uk japan and more than 50% of tier 1 capital held by the largest thousand banks worldwide although there are no reported numbers on collateral offsets to this aggregate exposure the inclusion of collateral would be expected to act

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As an important buffer against this risk the introduction of faz 157 subsequently required banks and other originators of derivatives to adjust the value of their marked market exposure by the risk of counterparty credit default this adjustment is referred to as credit valuation adjustment or cva a common method used to determine the mark the market at different

Points in time over the life of a derivative position is to simulate risk factor changes the simulated risk factor changes are then used to recalculate mark the market over time the derivative positions mark-to-market may be positive or negative the bank or derivatives dealer is primarily concerned with derivative positions that are marked to market in its favor

The initial exposure is defined as the current exposure or c ii expected exposure or ee is defined as the average of the distribution of exposures at each time step potential future exposure or pfe is defined as the expected exposure at a specific confidence level such as 95% effective expected exposure or triple e is defined as the maximum expected exposure at

Any time step expected positive exposure or epe is defined as the time weighted average of expected exposure effective expected positive exposure or ee pe is defined as the time weighted average of effective expected exposure the maximum potential future exposure or mp fe is referred to as the peak exposure total expected exposure or t ee is defined as the sum of

Current exposure and potential future exposure and is generally used to calculate cva effective expected exposure expected positive exposure an effective expected positive exposure are important components of cva related regulatory capital derivative counterparty credit risk exposure is intuitively thought of in terms of positive mark to market there is of course

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The opposite side of the simulation exercise to consider where the bank or derivatives dealer can be expected to owe the counterparty some mark the market in the future or what is otherwise referred to as negative exposure or negative mark to market in the same way that a banks potential positive exposure is used to calculate cva as a function of the counterparties

Risk of credit default potential negative exposure can be used to calculate a debt valuation adjustment or dva as a function of the bank’s own risk of default duration increases the banks exposure to the counterparties risk of default and in turn increases the amount of cva and net cva counter-intuitively the bank’s own credit deterioration reduces its net cva

Exposure which generates a profit whereas the bank’s credit improvement increases its net cva exposure which generates loss optimal mrm invites you to visit a store online to learn more about this and other available market risk elearning modules

Transcribed from video
Credit Valuation Adjustment | Basel 2.5 By Optimal MRM