CVA 'Demystified'

by Ignacio Ruiz of iRuiz Consulting

February 15, 2011

Abstract: Credit Value Adjustment (CVA) has been one of the "hot topics" in the financial industry since 2009. There have been several papers on the subject and the topic has been widely discussed in all banking conferences around the world. However, often, the fundamentals of this topic have been misunderstood or misinterpreted. Arguably, this is the result of a typical problem within quants (I am a quant): we have a tendency to explain things in unnecessarily complicated ways. This paper aims to bridge that gap. It will explain using simple examples how CVA has been priced into banking products for centuries and how it is, in fact, the root of the banking industry since its origin. It will show how CVA is nothing more than the application to modern financial derivatives of very simple and old concepts, and how its misinterpretation can lead to accounting mismanagement. The mathematical formulation for it will not be included in this text as it can be found in several publications.

JEL Classification: D40.

AMS Classification: 91B24, 91B25.

Keywords: CVA, DVA, Credit Value Adjustment, Debit Value Adjustment, Counterparty Credit Risk.

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