What is (CVA)?
the price that an investor would pay to hedge the counter party credit risk of a derivative instrument is termed as Credit Valuation Adjustment (CVA) . It impacts the mark to market value of an asset by the value of the CVA. CVA is the most widely known for valuation adjustments, collectively known as XVA.
Amidst the 2007/08 Global Financial Crisis, Credit Valuation Adjustment was introduced for fair value accounting . CVA has attracted much attention among derivative market participants and most of them have incorporated CVA in deal pricing.
The idea behind credit risk management, which also covers credit valuation adjustment, was developed due to the increased number of country and corporate defaults and financial fallouts.
The Credit Value Adjustment is by definition the difference between the risk-free portfolio and the true portfolio value that takes into account the possibility if a counter party's default. CVA also reflects the market value of the counter party credit risk.
What is (XCVA)?
XCVA is an extension of the better-known credit valuation adjustment (CVA), which is used to hedge against a bank’s aggregated counter party risk. XVA covers all derivatives valuation adjustments, including debit valuation adjustment (DVA) and fund valuation adjustment (FVA).
XCVA, or X-Value Adjustment, is a collective term that covers the different types of valuation adjustments relating to derivative contracts. The adjustments are made to account for the account funding, credit risk, and capital costs.
When initiating new trades in the derivatives market, traders incorporate XCVA into the price of the derivative instrument. It is X-Value Adjustment, and is used in financial valuation models. It’s a generic term referring to a number of different valuation adjustments in relation to derivatives, such as options and futures, held by investment banks.
Challenges Ahead :
These pricing adjustments have grown in number and significance since the 2008 financial crisis.
While a small number of banks are prepared for the regulatory changes and are actively managing CVA, the complexity and cost of implementing the necessary infrastructure remains a big job for the majority.
Common challenges for all entities computing CVA is obtaining the necessary market data required for the calculation and the expected exposure.
At an operational level at banks, the challenges of XCVA are deeper. XCVA implementation is requiring an operating model change to traditional front office trading operations, and significant investment in IT infrastructure is required to assist Finance, Risk and Operations functions with the change.