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Credit value adjustment: Difference between revisions
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===[[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 — | ===[[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]]. 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. But around 2011 it was very popular with [[investment banks]] who were feeling a credit squeeze. As this alleviated, strangely they began to get less enthusiastic about it, since the idea of having to pay to hedge away the risk of their own improving fortunes with [[credit derivatives]] started — oddly — to seem a bit silly to them. | ||
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? — but you would not be alone if you felt something tugging at your gut saying this feels wrong. And so it is. | ||