Credit Valuation Adjustment
Credit Valuation Adjustment (CVA) · Also known as: CVA, Counterparty Risk Adjustment
Credit Valuation Adjustment (CVA) is the market price of counterparty credit risk embedded in over-the-counter (OTC) derivatives. CVA measures the loss from counterparty default, accounting for both the probability of default and the exposure at that time. It has become a key component of derivative valuation and risk management since the 2008 financial crisis.
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When to use it
Use CVA for pricing OTC derivatives, especially long-dated products with significant counterparty credit risk. Essential for regulatory capital calculations (Basel III). Less relevant for exchange-traded products (central clearing reduces counterparty risk) or short-dated instruments.
Strengths & limitations
- Captures counterparty risk explicitly: adjusts prices for credit quality deterioration
- Consistent with market prices: CVA matches market spreads observed in similar trades
- Regulatory alignment: integrated into capital requirements and XVA frameworks
- Flexibility: can incorporate default correlation, collateral, and netting agreements
- Path-dependent computation: requires full Monte Carlo simulation of derivative exposure paths
- Default probability estimation: CDS spreads may diverge from true default probability; rating transitions are infrequent
- Correlation assumption: CVA is sensitive to asset-liability correlation (wrong-way risk) which is hard to estimate
- Collateral complexity: accounting for collateral agreements adds significant computational burden
Frequently asked
How is CVA different from DVA?
CVA is the loss if your counterparty defaults (negative impact on you). DVA (Debit Valuation Adjustment) is the gain if you default on your obligations (positive impact). In a portfolio with both long and short positions, DVA can offset CVA. Both are components of the broader XVA framework.
How do I estimate default probability?
Use market CDS spreads: the spread embeds market expectations of default probability. Fit a hazard rate curve from CDS quotes. Alternatively, use historical default rates from credit rating agencies or structural models (Merton) based on equity prices.
Why is collateral important for CVA?
Collateral reduces exposure at risk of default because if the counterparty defaults, you can liquidate the collateral to recover losses. With effective collateral agreements, CVA can be reduced by 50% or more, depending on collateral frequency and haircuts.
What is wrong-way risk and how does it affect CVA?
Wrong-way risk occurs when the derivative exposure and counterparty credit are correlated positively (e.g., long FX option on a currency that will depreciate if the counterparty country's credit deteriorates). Wrong-way risk increases CVA significantly and standard Monte Carlo methods underestimate it.
Sources
How to cite this page
ScholarGate. (2026, June 3). Credit Valuation Adjustment (CVA). ScholarGate. https://scholargate.app/en/quantitative-finance/credit-valuation-adjustment
Which method?
Set this method beside its closest kin and read them side by side — the library lays the books on the table; the choice is yours.
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