by Kevin Hoff, Senior Manager, KPMG Inc.
Over the past two to three years, an increasing focus has been placed on incorporating credit risk in the fair value of financial instruments. The emphasis can be traced to the global financial crisis and European sovereign debt crisis experienced between 2008 and 2011. These events highlighted the need for more accurate pricing of credit at inception of transactions and the dynamic quantification of credit exposures throughout the life of a trade, to more accurately reflect the inherent underlying credit risk. The crises brought to light weaknesses in the way that financial institutions and corporates across the globe were incorporating credit risk into financial instrument valuation, accounting, disclosure and risk management processes.
Credit risk relates to the risk that a counterparty will default before the maturity/expiration of a transaction and will consequently be unable to meet all contractual payments, thereby resulting in a loss for the other party to the transaction. A valuation adjustment for credit reflects the amount at which such risk is measured by a market participant.
What is CVA / DVA?
The valuation adjustments that have become prevalent across global markets are those that reflect the two-way risk of loss for the reporting entity (the corporate in this case) and the counterparty. These are commonly referred to as a credit valuation adjustment (CVA) – i.e., an adjustment reflecting the credit risk exposure to the counterparty – and a debt valuation adjustment (DVA) – i.e., an adjustment reflecting the corporate’s own credit risk to which the counterparty is exposed.