Glossary term
Credit Valuation Adjustment
Credit valuation adjustment, or CVA, is an adjustment to a derivative or trading exposure’s value for the counterparty’s credit risk.
Updated
Read time
What Is Credit Valuation Adjustment?
Credit valuation adjustment, or CVA, is an adjustment to the value of a derivative or trading exposure for the counterparty's credit risk. It reflects the possibility that the counterparty may default before the contract's expected cash flows are fully received.
In plain English, CVA asks what the contract is worth after considering that the other side might not perform. It connects valuation, counterparty credit risk, and regulatory capital.
Key Takeaways
- CVA adjusts a financial contract's value for counterparty credit risk.
- It is especially relevant for derivatives and long-dated trading exposures.
- CVA can change as credit spreads, exposures, collateral, and market conditions change.
- Basel rules include a CVA risk framework for regulatory capital.
- CVA is not the same as realized default loss; it is a valuation adjustment for risk.
How CVA Works
A simplified intuition for CVA is:
In this expression, EPE is expected positive exposure to the counterparty, PDcounterparty is the chance the counterparty defaults over the relevant horizon, and Loss Given Default is the share of exposure not recovered after default.
For example, if a bank has a derivative that is valuable only if the counterparty performs, widening credit spreads for that counterparty can increase CVA and reduce the reported value of the exposure even before any default occurs.
Why CVA Moves
Driver | Effect on CVA |
|---|---|
Higher exposure | Usually increases the possible loss amount. |
Higher default probability | Usually increases the adjustment. |
Lower recovery expectation | Usually increases loss given default. |
Collateral and netting | Can reduce effective exposure. |
Market volatility | Can increase potential future exposure. |
Financial Consequences
CVA matters because it can affect earnings, risk limits, pricing, hedging, and regulatory capital. A trade that looks attractive before counterparty credit risk may look less attractive after CVA is included.
The adjustment also makes counterparty credit quality visible in valuation. If a counterparty becomes weaker, the contract's value can decline even if the underlying market position has not moved against the bank.
What CVA Does Not Tell You
CVA is model-dependent. It relies on exposure estimates, default probabilities, recovery assumptions, collateral behavior, netting enforceability, and market inputs. It can be sensitive to assumptions, especially for complex or long-dated derivatives.
It is also not a cash loss by itself. It is a valuation and capital concept that reflects expected credit risk. Actual losses depend on default, closeout, collateral, recovery, and market conditions at the time.
CVA is also linked to hedging. Banks may hedge counterparty credit spread movements or exposure changes, but hedging can be imperfect because exposure, collateral, default risk, and market risk all move together. That is one reason CVA became a major focus after the global financial crisis.
The Bottom Line
Credit valuation adjustment brings counterparty credit risk into the value of a derivative or trading exposure. It helps price and manage the risk that the other side of a contract may fail before settlement.