Credit Value Adjustment: Incremental CVA from Interest Rate Swaps

Egill Ludviksson

Student thesis: Master thesis

Abstract

In today’s regulatory environment, banks must set aside capital and adjust their booked asset value in accordance with their counterparty credit risk in order to comply with regulatory requirements. This has encouraged banks to actively hedge this risk to decrease exposure and thereby gain capital relief. Further, as a consequence of regulatory actions, banks are increasingly considering how costs associated with credit-value-adjustments (CVA) may be minimized. Such measures commonly involve mitigating counterparty risk by e.g. hedging the exposure. Banks have also begun to manage CVA on trade level, by allocating CVA of new trades to the dealers’ books. This is the so-called incremental CVA, which depends on how the value of a new trade correlates with the existing portfolio. Nowadays, international banks have started to link incremental CVA with the performance-based compensation for their dealers, with the intention to align the interests of the bank and their dealers more accurately. The objective of this thesis is to study the composition of CVA and analyze its dynamics associated with new transactions entering a netting set via incremental CVA calculations. The results of the numerical analysis highlight that the incremental CVA of trades depends on its interplay with existing trades. Those findings demonstrate that the incremental CVA for a transaction can be different for different banks depending on their existing portfolio. Furthermore, the importance of credit quality in over-the-counter (OTC) transactions is manifested as two counterparties of different credit quality are benchmarked together.

EducationsMSc in Applied Economics and Finance, (Graduate Programme) Final Thesis
LanguageEnglish
Publication date2019
Number of pages90
SupervisorsMads Stenbo Nielsen