Definition
CVA quantifies the expected loss from a counterparty's potential default on OTC derivative obligations. It adjusts the risk-free price downward to account for the probability-weighted cost of default. CVA is calculated as the expected positive exposure multiplied by the counterparty's default probability and loss given default. Banks must hold capital against CVA risk under Basel III.
functions Formula
CVA = Σ(Discount Factor × Default Prob × Expected Exposure × LGD)
lightbulb Example
A 5-year swap with a BBB counterparty has expected positive exposure averaging $5M. Default probability is 2% and LGD is 60%. CVA ≈ $5M × 2% × 60% = $60K, reducing the swap's value by $60K.
verified_user Key Points
- Prices counterparty default risk into derivatives
- Required under Basel III capital rules
- DVA is the bilateral counterpart (own default risk)
- CVA desks actively hedge counterparty exposure