Counterparty Risk terms

[liewpw05]

Hi David,

Could you help enlighten me on the differances between the following terms used in the Canaborro reading on measuring and marking counterparty risk : credit valuation adjustment and market value of credit risk?

Is the net market value of credit risk = V(B)-V(A), the same are credit value adjustment? From the exhibit 9.2 in the Canaborro reading , it seems they are the same.So i gather that exhibit 9.2 is showing how the credit valuation adjustment is computed using information on the PFE profile of the counterparties and the risk-nuetral mean loss rate?

Note :V(B) is defined as value to A if B defaults and V(A) is defined as Value to B if A defaults

Thank you

Regards,
Peggy

 

[David Harper CFA FRM]

Hi Peggy

Apologies for delay.

"Is the net market value of credit risk = V(B)-V(A), the same are credit value adjustment?"

Yes, because the example (implicitly) assumes that the market price of the swap includes nothing for default/credit risk (i.e., "the swap rate is the at-market rate for default free counterparties"). Because the valuation includes a ZERO (before the pricing) for counterparty default, the CVA is V(B) - V(A). This has been traditionally standard practice, to value the instrument without counting counterparty (default) risk; in such a case, the CVA = market value of the counterparty risk.

So, the difference is merely "does the valuation already include, effectively, the market price/value of the default risk?" The CVA is the adjustment required to make up the difference. To use Canabarro's example,

net market value of default (counterparty) risk = 5

The CVA is whatever brings the market price into balance:

if (as the example) price already includes 2 for counterparty risk, then CVA = 3
But if (now this is more like 9.2), the price includes 0 for counterparty risk (i.e., a mid market valuation that ignores counterparty risk), then CVA 5

So, same concept, the CVA is just the adjustment that gets the full "market value of credit risk" recognized.

David

 

[ajsa]

Hi David,

Is V(B) or V(A) the counterparty exposure?

BTW Is counterparty exposure a market value (than FV)? what is the different between counterparty exposure and current counterparty exposure?

I am asking also because it seems some "exposures" are FV and some are MV. for example it seems that the EE in the formula of market value of credit risk (V(t) = EE*(t) × L*(t) × C(t)) is FV than MV.

Thanks.

 

[ajsa]

Hi David,

in your example, "Assume this valuation already includes an effective market value of 2 for the default risk to Party A". I wonder how to define/measure the 'effective market value for the default risk to Party A"?

thanks.