Difference between revisions of "Credit value adjustment"

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{{g}}''Warning: ramblings of an untutored maniac here.''
 
{{g}}''Warning: ramblings of an untutored maniac here.''
 
===[[Credit value adjustment]]s===
 
===[[Credit value adjustment]]s===
A [[credit value adjustment]] — to its friends '''[[CVA]]''' — is a calculation made by financial reporting types to [[financial instrument]]s one holds to account for changes in the [[creditworthiness]] of the [[issuer]] of those instruments since their issue. For a liquid instrument the [[CVA]] ought really to be baked into the [[mark-to-market]] value of the instrument. For a [[Variation margin|collateralised]] one, it ought to be small. As far as this [[Jolly Contrarian|bear of little brain]] can see, it ought really to be the difference between the [[present value]] of the notional [[cashflows]] due on that instrument (that is, ignoring the risk of [[default]]) and the price at which that instrument is trading.  
+
A [[credit value adjustment]] — to its friends '''[[CVA]]''' — is a calculation made by financial reporting types to [[financial instrument]]s one holds to account for changes in the [[creditworthiness]] of the [[issuer]] of those instruments since their issue. For a liquid instrument, the [[CVA]] ought really to be baked into the [[mark-to-market]] value of the instrument. For a [[Variation margin|collateralised]] one, it ought to be small. As far as this [[Jolly Contrarian|bear of little brain]] can see, it ought really to be the difference between the [[present value]] of the notional [[cashflows]] due on that instrument (that is, ignoring the risk of [[default]]) and the price at which that instrument is trading.  
===[[Debt value adjustment]]s  — [[snake oil]] alert===
+
===[[Debt value adjustment]]s  — {{t|snake oil}} alert===
 
:''“[[DVA]] has caused a lot of confusion because banks are allowed to record gains as their credit quality deteriorates. While there are pros and cons to including [[DVA]] in earnings, most people see it as accounting gimmickry that doesn’t reflect any true economic value.”
 
:''“[[DVA]] has caused a lot of confusion because banks are allowed to record gains as their credit quality deteriorates. While there are pros and cons to including [[DVA]] in earnings, most people see it as accounting gimmickry that doesn’t reflect any true economic value.”
 
::—David Kelly, Quantifi, 2009, quoted in [https://www.euromoney.com/article/b12kjc667rjrsq/the-truth-behind-cvas-dvas-and-banking-results?copyrightInfo=true Euromoney]
 
::—David Kelly, Quantifi, 2009, quoted in [https://www.euromoney.com/article/b12kjc667rjrsq/the-truth-behind-cvas-dvas-and-banking-results?copyrightInfo=true Euromoney]
  
The imposition of [[CVA]] adjustments during the [[global financial crisis]] — it was a [[Basel]] requirement — where counterparties had, effectively, to discount the value of their claims under [[derivative]] contracts due to deterioration in their counterparties’ [[creditworthiness]], led resourceful types to wonder whether they shouldn’t also be able to discount the book value of their ''[[liability|liabilities]]'' under the same {{t|contract}}s due to a deterioration in their ''own'' [[creditworthiness]]. This they called “[[debt value adjustment]]s”, and while it was a thing, it didn’t fare quite so well and these days there aren’t as many Investopedia articles about it.
+
The imposition of [[CVA]] adjustments during the [[global financial crisis]] — it was a [[Basel]] requirement — where counterparties had, effectively, to discount the value of their claims under [[derivative]] contracts due to deterioration in their counterparties’ [[creditworthiness]], led resourceful types to wonder whether they shouldn’t also be able to discount the book value of their ''[[liability|liabilities]]'' under the same {{t|contract}}s due to a deterioration in their ''own'' [[creditworthiness]].  
  
There is a neat logic to this — if I consider [[out-of-the-money]] exposures to be my term [[indebtedness]], then if my prospects have worsened, I would be able to buy this back at a discount to its face value for exactly the same reason, so why shouldn’t I mark it down? —  but you would not be alone if you felt something tugging at your gut saying this feels wrong. And so it is.
+
There is a neat logic to this — if I consider [[out-of-the-money]] exposures to be my term [[indebtedness]], then if my prospects have worsened, I would be able to buy this back at a discount to its face value for exactly the same reason, so why shouldn’t I mark it down?
  
If you think your own-credit deterioration is an excuse to book a profit, you should get your coat. Just because, as you lurch towards [[insolvency]], the value of your liabilities ''to others'' tends to zero, it doesn’t mean their cost ''to you'' tends to zero. You are still fully liable for the risk-free amount of that [[indebtedness]], come what may. That you should have collapsed into ignominious torpor of [[bankruptcy]] before being able to honour it does not mean that obligation doesn’t exist, and it certainly doesn’t go to your [[pnl]].
+
So the [[investment bank]]s did, and in size. They called these “[[debt value adjustment]]s”, and while it was a thing, it didn’t fare so well and these days there aren’t as many Investopedia articles about it. But, around 2011, it was the talk of the smoky salons where credit traders would gather to complain to each other about the prevailing squeeze on their credit. Strangely, as this alleviated, they grew less enthusiastic about having to pay to hedge away the cost of their own improving fortunes with [[credit derivatives]] as, oddly it began to seem a bit silly.
  
“But,” I hear you cry, “I could buy that [[indebtedness]] back in the market at the [[discount|discounted]] va —”
+
So you would not be alone if you felt something tugging at your gut saying this seems a bit [[snake oil]]-y. Because it is. If you think your ''own'' credit deterioration is an excuse to book a ''profit'', you should get your coat. Just because, as you lurch towards [[insolvency]], the value ''to your creditors'' of your [[liabilities]] tends to zero, it doesn’t mean their cost ''to you'' tends to zero. You are still fully liable for that [[indebtedness]], come what may. That you should have collapsed into ignominious torpor of [[bankruptcy]] before being able to honour it does not mean your obligation doesn’t exist, and it certainly shouldn’t go towards your [[pnl]].
 +
 
 +
“But,” I hear you cry, “I could buy that [[indebtedness]] back in the market at that [[discount|discounted]] va —”
  
 
WITH WHAT, DEAR LIZA? The theory is ''your business is swan-diving into the side of a hill''. If you had free [[cash]] available to buy out all your debts, ''said hill would not be filling up your entire field of vision''. You don’t have any goddamn money to buy your debts back. That is your ''exact'' problem.
 
WITH WHAT, DEAR LIZA? The theory is ''your business is swan-diving into the side of a hill''. If you had free [[cash]] available to buy out all your debts, ''said hill would not be filling up your entire field of vision''. You don’t have any goddamn money to buy your debts back. That is your ''exact'' problem.

Latest revision as of 10:26, 9 November 2019

The Jolly Contrarian’s Glossary

The snippy guide to financial services lingo.™
For the full index, click here

Warning: ramblings of an untutored maniac here.

Credit value adjustments

A credit value adjustment — to its friends CVA — is a calculation made by financial reporting types to financial instruments one holds to account for changes in the creditworthiness of the issuer of those instruments since their issue. For a liquid instrument, the CVA ought really to be baked into the mark-to-market value of the instrument. For a collateralised one, it ought to be small. As far as this bear of little brain can see, it ought really to be the difference between the present value of the notional cashflows due on that instrument (that is, ignoring the risk of default) and the price at which that instrument is trading.

Debt value adjustmentssnake oil alert

DVA has caused a lot of confusion because banks are allowed to record gains as their credit quality deteriorates. While there are pros and cons to including DVA in earnings, most people see it as accounting gimmickry that doesn’t reflect any true economic value.”
—David Kelly, Quantifi, 2009, quoted in Euromoney

The imposition of CVA adjustments during the global financial crisis — it was a Basel requirement — where counterparties had, effectively, to discount the value of their claims under derivative contracts due to deterioration in their counterparties’ creditworthiness, led resourceful types to wonder whether they shouldn’t also be able to discount the book value of their liabilities under the same contracts due to a deterioration in their own creditworthiness.

There is a neat logic to this — if I consider out-of-the-money exposures to be my term indebtedness, then if my prospects have worsened, I would be able to buy this back at a discount to its face value for exactly the same reason, so why shouldn’t I mark it down?

So the investment banks did, and in size. They called these “debt value adjustments”, and while it was a thing, it didn’t fare so well and these days there aren’t as many Investopedia articles about it. But, around 2011, it was the talk of the smoky salons where credit traders would gather to complain to each other about the prevailing squeeze on their credit. Strangely, as this alleviated, they grew less enthusiastic about having to pay to hedge away the cost of their own improving fortunes with credit derivatives as, oddly it began to seem a bit silly.

So you would not be alone if you felt something tugging at your gut saying this seems a bit snake oil-y. Because it is. If you think your own credit deterioration is an excuse to book a profit, you should get your coat. Just because, as you lurch towards insolvency, the value to your creditors of your liabilities tends to zero, it doesn’t mean their cost to you tends to zero. You are still fully liable for that indebtedness, come what may. That you should have collapsed into ignominious torpor of bankruptcy before being able to honour it does not mean your obligation doesn’t exist, and it certainly shouldn’t go towards your pnl.

“But,” I hear you cry, “I could buy that indebtedness back in the market at that discounted va —”

WITH WHAT, DEAR LIZA? The theory is your business is swan-diving into the side of a hill. If you had free cash available to buy out all your debts, said hill would not be filling up your entire field of vision. You don’t have any goddamn money to buy your debts back. That is your exact problem.

“But I could borrow so —” and here, dear reader, follows a pause. “Oh, hang on. I think I see the problem here.”

Right. You don’t have any money, so you would have to borrow it. Even if you could find someone prepared to lend to a soon-to-be-bankrupt company (look, it does happen), it would lend to you at your current state of indebtedness. So you would be trading your apparently cheap indebtedness for more expensive indebtedness.

See also