Before the financial crisis, the credit risk on derivatives were mostly considered insignificant. This was a view that was quickly revised when risks increased and traders started adjusting the values quoted on derivatives from counterparty to counterparty, and so market prices began to diverge.
Derivative valuations adjustments – holistic view
Before the financial crisis the credit risk onderivatives were mostly considered insignificant, – a
view that was quickly revised when risks increased and traders started adjusting the values
quoted on derivatives from counterparty to counterparty, and so market prices began to
diverge. Naturally this evolved into calculating “valuation adjustments” from the mid-market
price as part of trading to account for the credit risk of the counterparty with whom you were
trading with. The calculation of these adjustments became standard among banks and
regulation subsequently required them to be included as part of the fair value of derivatives
within financial statements.
More recently, with the introduction of IFRS 13, the concept of “non-performance risk” within
fair value was included within the accountancy standards of any corporates who had elected
up to IFRS standards. Non-performance risk covers anything that could influence the likelihood
of an obligation being fulfilled. For derivatives the credit risk is one of the more prominent
nonperformance risks but is not the only risk.
In addition, the methodologies required to quantify such risks are not trivial. In addition to
the value of these adjustments significantly impacting the purchase price of a derivative, from
banks or counterparties factoring them into the value, on restructure the change in the value of
these adjustments can often be the value-driver for the cost borne or savings received e.g. as
the new restructured trade may have greater valuations adjustments which would be a cost to
the restructure or lesser adjustments which would be a release to the restructure.
This paper aims to summarise the leading valuation adjustment calculation methodology and
briefly explain and summarise the key valuation adjustments produced.
Core Valuation Adjustments: Credit Valuation Adjustment (CVA)
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