Credit Valuation Adjustment (CVA)∗†

Shahram Alavian‡
Jie Ding§
Peter Whitehead¶
and
Leonardo Laudicina∥

October 9, 2010

Abstract
This paper provides an overview of counterparty valuation adjust-
ments, within the context of collateralized and un-collateralized trad-
ing relationships. The counterparty valuation adjustment terms are
derived by decomposing an un-defaultable portfolio into a set of bi-
nary states. These states are a set of market values of the portfolio
(positive or negative), default states (default or no default) and re-
coveries (recover the recovery amount or not). In particular, the asset
charge and liability benefit are formulated for both un-collateralized
and collateralized portfolios while different models are provided for the
collateral transfer calculations of the collateralized trading accounts.

∗
The opinions expressed are those of the authors and do not necessarily reflect the
views of their employers, or other members of their staff.
†
For questions and comments please contact Shahram Alavian at
shahram [email protected].
‡
Lehman Brothers
§
Nomura
¶
Deutsche Bank
∥
Nomura

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1 Introduction
According to the International Swap and Derivative Association (ISDA), the
notional amount outstanding in over-the-counter (OTC) derivative trades,
in the seven year period, between 2000 and 2007, has grown seven times [1].
Such an exponential growth in contractual commitments among financial
entities demands a solid understanding and the proper evaluation of coun-
terparty risk of the trading book.
Once two counterparties enter into a trade, besides market risk, they also
take credit risk against each other. The risk of financial loss due to default
of trading counterparties is referred to as counterparty credit default risk. In
most cases, this risk is not considered in direct evaluation of the trades and,
therefore, needs to be adjusted appropriately to reflect the risk should either
of the counterparties default on their commitments. The adjustment to the
value of a default free trading book is what is usually referred to as credit
(or counterparty) valuation adjustment (CVA).

2 Governance of Trading Relationships

In most cases, in order to evaluate a default free trade, a trade specification
is all that one needs. However, when considering the same trade with coun-
terparty default considerations, one would also need to carefully examine
the agreements under which the trading account is established. Since these
agreements are a set of provisions that could be affecting all trades, they
are usually not repeated in the individual trade confirms but they do, in a
collective way, affect the value of the trades within the account.
In reality, there may be different agreements reached between any two coun-
terparties. However, the ISDA Master Agreement introduced by ISDA is one
of the most established agreements among most trading firms.

2.1 Trading Relationship Under ISDA Master Agree-

ment
It is important to appreciate that though the counterparty 1 with positive
value of the portfolio is “in-the-money” with its trading counterparty, it is
probably “out-of-the-money” with its hedging counterparty who is expecting
the same incoming cash flow. Such a tight relationship, particularly among
large dealers, creates a strong domino effect in defaults when one counter-
party fails to deliver its commitment. For this reason dealers are encouraged
1
Specially in the case of a dealer

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to find ways in order to reduce their counterparty risk [2]. The process of
reduction in counterparty risk starts, prior to any trading activities, at the
time when the trading agreement is to be signed. One of the most important
documents to be signed by the counterparties regarding the governance of
their trading relationship is the ISDA Master Agreement2 . The ISDA Master
Agreement [3] has the objective of risk mitigation for both counterparties.
Possibly the most important aspect of the ISDA Master Agreement is that
the trades under this agreement form a single agreement. This is very im-
portant as it allows the parties to aggregate the amounts owing, by each of
them, and replace them with a single net amount payable by one party to the
other. Such agreement, therefore, enforces the counterparty risk to be evalu-
ated on a portfolio level and not on a trade-by-trade basis. In general, where
there are multiple ISDA Master Agreements, all trades under each agree-
ment should form a single portfolio with no cross-netting between trades in
different portfolios. To appreciate the effect of multiple master agreements,
a good example to consider is the counterparty risk of two opposite but iden-
tical trades between two counterparties where each trade is booked under a
different agreement. While this trade shows no market risk, due to asym-
metry of exposure it is clearly subject to credit quality of both counterparties.

2.2 Trading Relationship Under Credit Support An-

nex
Though the ISDA Master Agreement reduces the risk by netting across all
trades under its agreement, it still leaves a net residual exposure which, as
the portfolio ages, can become substantial. Though for one portfolio one
residual exposure just ”maybe” substantial, for a dealer managing a large
number of portfolios, the substantial exposures do exist. Since the dealer
cannot easily sell the OTC trade to another client, it finds the exposure
specific to the client; leaving the dealer still with more counterparty risk
that it would like to have. Therefore, dealers are still inclined to have other
mechanisms built in to their trading relationships under ISDA in order to
minimize the residual counterparty risk even further. This is usually achieved
by including an annex to their existing ISDA called Credit Support Annex
(CSA). A CSA defines the terms under which collateral is posted or trans-
ferred between counterparties in order to mitigate counterparty credit risk3 .
2
For the purpose of consistency, all portfolios in this article are assumed to be covered,
at the minimum, under an ISDA Master Agreement.
3
Portfolios under CSA, due to the collateralized nature of the agreement,
are called collateralized portfolios and those without CSA should be treated as

3
Terms in the CSA include thresholds, minimum transfer amounts, eligible
securities and currencies, haircuts applicable to eligible securities and rules
for the settlement of disputes arising over valuation of derivative positions.
The threshold level is the credit that one counterparty extends to another,
usually, conditional on its credit worthiness. The type and the haircut of the
collateral are also predefined within the agreement. The minimum transfer
amount is the buffer amount above the threshold to ensure some reasonable
price movements occurs before the call for collateral is made. The main con-
cept behind the CSA is the provisioning of the inflow of cash coming from
the entity with out-of-the-money portfolio towards its trading counterparty.
Depending on the direction of the flow of cash the agreement is of either
bilateral or unilateral. In a bilateral agreement, which is the most common,
both counterparties can call for collateral. In unilateral agreement, on the
other hand, only one predefined counterparty has the right to call. As an
example, consider the case of bilateral agreement with zero threshold and
zero minimum transfer amount. This agreement essentially has the effect of
constantly closing the book at the end of one period and reopening the same
identical position at the beginning of the next; very similar to futures trading
account. Therefore, in this case, the source of the exposure is the ”change”
of the portfolio value over and above the client’s threshold since the last
time collateral was exchanged. Another way of looking at the CSA bilateral
agreement is through the concept of trade financing. In order to maintain
a trade one needs money. This money can be financed by placing the posi-
tion in a secure account as a collateral against the fund. This is a common
practice in Repurchase Agreements (repo) except that in repo, OTC trades,
since they are not transferable, are not accepted. In this case the counterpar-
ties themselves finance the in-the-money positions. In a bilateral agreement
both counterparties finance each other while in the unilateral agreement the
counterparty who has the right to call collateral enjoys the financing only. A
simple and naive example will provide more insight. Imagine a client with a
bilateral CSA agreement, covering zero threshold and zero minimum trans-
fer amount for both counterparties, who is interested in selling a call to its
dealer. In this case, the dealer, can keep the premium as a collateral tied up
to the trade since the value of the premium is sufficient to cover the option.
The dealer has just financed the client for its option. During the next margin
period, if the value of the option, for whatever the reason, drops, the client’s
account now is in the money and it can now borrow the difference. However,
if the option gains more value it would be the dealer who is in the money
and the client would then lends cash to the dealer. Note that if the option
un-collateralized portfolios.

4
monotonically goes out of money until maturity, the client will end up col-
lecting the entire premium of the option that it had sold without having to
finance the trade.
On the calculation date which falls at the beginning of each margin period,
the two counterparties evaluate their net positions and measure how far this
value has changed from the last time any collateral has been transferred.
The counterparty with the positive change, if it has the right to call for the
collateral, will compare the change with the addition of its counterparty’s
threshold and the minimum transfer amount. If the value is lower, the ex-
posure is within the credit line and no collateral should be transferred. If
the value is higher, the counterparty with the positive change is entitled to
receive collateral equal to the difference between the change and the thresh-
old level; reducing its risk to the threshold level. This way, the counterparty
maintains its exposure, maximum to the credit line it has granted, regardless
of the value of the trade.
Therefore, if a counterparty entitled to the collateral does not receive the
full payment during the grace period, the owed counterparty could mark the
position as of the last evaluation date and would close both the trades and its
corresponding hedges. It is important to note the implicit risk, to which the
surviving counterparty is possibly exposed should the market moves deeply
out-of-the-money with hedging positions while the actual trades are being
closed and marked as of the calculation date. This is particularly of rele-
vance when the number of OTC trades are large, since the larger the number
of trades the more difficult it is to deal with complications arising from the
close-out process. The close-out period can range from days (a small coun-
terparty) to months (another dealer or broker).

3 Default Process Under ISDA Master Agree-

ment
Roughly speaking, default is a credit event that allows one counterparty to
record the last evaluation of the portfolio and initiate closing out the po-
sitions and pursue the owing counterparty for the value of the portfolio or
the remaining of the collateral owed. Under ISDA, there are a number of
situations defined as default. They are, failure to pay, breach of agreement,
credit support default, default under special transactions, cross default, and,
bankruptcy. One important trigger for the event is when the collateral payer
does not transfer the collateral within a set period, called “grace period”.
Once the default occurs, the non-defaulting counterparty has the right (but

5
not the obligation) to serve the default notice, by hard copy, to allow the
defaulting counterparty to remedy the situation, after which the termination
date is automatically triggered. This grace period is usually a pre-defined
in CSA, under which the defaulting counterparty can remedy the situation.
This period depends on the type of ISDA, the products it covers and its
governing jurisdiction. It usually falls some time within a month. Once the
early termination is triggered , both counterparties resort to two methods
of evaluating the net portfolio. For most liquid trades a third party dealer-
quote and for most of the illiquid trades the replacement cost is used. In
practice, it is not uncommon for the surviving counterparty to drastically
inflate the positive-valued trades and deflate the negative-valued trades, and
for the defaulting counterparty, under the administration, to dispute all val-
ues; making the recovery a long and indeterministic process that can drag
on for years. Another commonly overlooked concept is that the surviving
counterparty has the right but not the obligation to serve the default no-
tice. If it decide not to proceed with the default notice, the trade remains
live until maturity with no exchange of cash flow. Imagine a dealer where
it has sold a series of options to a counterparty, under a single trade, for a
premium. If the client defaults, the dealer may choose not to serve the notice
and enjoy the cash in hand for as long as it finds it beneficial. In reality,
the decision of not serving the default notice depends on many factors that
may not even be based on maximizing the value of the trade. A surviving
counterparty, with a few months before the end of its accounting year and
a large exposure would probably decide to delay serving the default notice
until the end of the accounting year, if the re-valuation of the trade would
create a large write-down on its total asset. Regardless of when the notice
is served, at the end of a long negotiation period and costly legal proceeding
the surviving counterparty has to wait, as a unsecured bond holder, to be
paid any recovery amount that the administration can provide. The larger
the defaulting counterparty the longer the process of recovery.
The above paragraph is far from being the appropriate source for default
proceedings. It is meant to provide a f eel regarding what happens when a
counterparty defaults under ISDA agreement. In the following paragraphs
a set of commonly used formulae for valuing a trade, in the presence of the
counterparty default, is derived. The advantage of deriving these formulae
is to give insight to all the implicit assumptions and their relevance when
applied to real practical appllications.

6
4 Credit Valuation Adjustment
Consider the case where a LIBOR quality dealer enters into a back-to-back
trade where it purchases a positive cash flow from a sub-LIBOR counterparty
and sells an identical cash flow back to another LIBOR quality dealer for the
same price. Without any counterparty risk consideration the dealer marks
no profit/loss. However, in reality, this intermediary dealer has a loss due to
the differential in counterparty risk that it maintained and did not pass to
the other LIBOR quality dealer. To evaluate the adjustment, one common
analogy to this differential value is to assume that the two counterparties im-
plicitly sold each other an option to default on the trade. In the mentioned
example, since the intermediary dealer has bought a positive cash flow, it has
a positive receivable from the sub-LIBOR counterparty. Since it is at risk of
counterparty’s default, it has implicitly sold an option-to-default for which
it never received the money. Therefore, the dealer should “charge” its trader
the value of this option-to-default. On the other hand, the sub-LIBOR coun-
terparty has implicitly bought the same option-to-default for which it never
paid. Based on the same accounting principle, it should give its trader the
“benefit” equal to the charge applied to the dealer’s trader. Since the positive
amount is represented as an asset on the dealer’s trading book, the charge
by the dealer to this underlying trade is commonly termed “asset charge”.
Based on the same token, the benefit given to the sub-LIBOR counterparty
is called “liability benefit”4 . Note that, in general, one’s asset charge is its
counterparty’s liability benefit. In summary, asset charge is a receivable that
was not charged and liability benefit is a payable that was not paid.
During a given period, either or both counterparties may default. Should
that happen, the net exposure of the portfolio, at the time of default, and
the portion of the amount to be lost determines the risk of the surviving
counterparty. Therefore, in general, there are three contributing factors to
counterparty risk: 1) credit states of the counterparties, 2) the credit risk
free market value of the portfolio and 3) rates of recovery of both counter-
parties. To properly model the counterparty risk, all three should be viewed
stochastic with their interdependence considered.

4
The terms “asset charge” and “liability benefit” are chosen by preference only.

7
5 Decomposition of an Un-collateralized Port-
folio
The motivation for this section is to formulate the CVA from the initial value
of a portfolio which is not subject to counterparty default risk. This value is
then expanded into a set of binary states with different cash flow directions
(positive and negative), default states (default or not ) and rate of recoveries
(receive the rate of recovery or not) of both counterparties.
Under the pricing measure, the value of the portfolio, V (t), as of time t,
under the filtration Ft with

V (t) = B(t, t′ )E [V (t′ )|Ft ] (t′ > t) (1)

is considered. The bond price B(t, t′ ) defines the value of a risk free bond
at time t maturing at t′ . The filtration Ft does include information on the
counterparties’ credit states. The trade may even be of credit derivative in
nature depending on the credit states of verity of issuer names including any
of the two counterparties as underlying market factors.
In order to understand the risk of a defaultable portfolio, one needs to know
the conditional expectation of the portfolio in future time horizons. This
is called “seasoning” or “aging” of the portfolio and it should consider the
time dependency of the portfolio such as maturing underlying trades, in and
outflow of cash flows as the portfolio marches along in to the future.
The common, and perhaps safe, interpretation of the ISDA Master Agree-
ment regarding default is that at the time of either counterparties’ default
the market value of the portfolio is recorded as the balance owing and all
trading activities stop. Therefore, one can model the seasoning of the port-
folio only conditional on both counterparties’ survival.
At this point, it is important to note that the definition of default does not
necessarily mean the liquidation of the entity. According to ISDA, definition
of “default” covers a number of states including restructuring. Therefore, the
“first-time-to-default” is chosen since an entity may default more than once.
In order to do this, one may define a random time τ as the time that the en-
tity defaults for the first time. Note that for the purpose of this formulation,
there is no need to condition τ to follow any process as long as it satisfies the
first-time-to-default condition. For illustrative purposes, consider the coun-
terparties primed and unprimed, each with first-time-to-default of τ and τ ′5 ,
5
All primed and unprimed quantities would, hereafter, correspond to primed and un-
primed counterparties. Later on, for the purpose of clarity, the CVA will be seen from the
unprimed counterparty’s point of view.

8
respectively.
Using the indicator function

{
1, if θ = true
Iθ ≡ (2)
0, if θ = false

the values of the default free portfolio V (t) can now be extended by both
default states to time t as,

V (t) =V (t|τ ′ > t, τ > t) + V (t|τ ′ < t, τ < t) +

V (t|τ ′ < t, τ > t) + V (t|τ ′ > t, τ < t)
=Vs (t, τ, τ ′ ) + Vd (t, τ, τ ′ ) (3)

where the surviving portfolio Vs (t, τ, τ ′ ) and the defauled portfolio Vd (t, τ, τ ′ )
are defined as

Vs (t, τ, τ ′ ) ≡ V (t) [Iτ ′ >t .Iτ >t ] (4)

Vd (t, τ, τ ′ ) ≡ V (t) [Iτ ′ <t .Iτ <t + Iτ ′ <t .Iτ >t + Iτ ′ >t .Iτ <t ] (5)

Conditional on both counterparties surviving until t, the surviving portfolio

is one that is subject to risk while the defaulted portfolio, due to the indi-
cator functions is null. The value of the surviving portfolio Vs (t, τ, τ ′ ) can
now be expanded to two binary states of incoming and outgoing cash flows as

Vs (t, τ, τ ′ ) = max [Vs (t, τ, τ ′ ) , 0] − max [−Vs (t, τ, τ ′ ) , 0]

≡ Vs+ (t, τ, τ ′ ) − Vs− (t, τ, τ ′ ) . (6)

Selecting an evaluation horizon, η, to be some δt further away from t.

η ≡ t + δt. (7)

The forward default states, of both counterparties, can be chosen to fall be-
fore or after time η. One can expand unity into a complete set of default

9
states as

1+ =Iτ ′ <η .Iτ >τ ′ + Iτ ′ <η .Iτ <τ ′ + Iτ ′ >η

and

1− = Iτ <η .Iτ ′ >τ + Iτ <η .Iτ ′ <τ + Iτ >η (8)

Note that for the continuous time axis the probability of mutual default
is automatically null. Therefore, in the above equation, states for mutual
defaults are not included. The right hand side (r.h.s) of either equations is
the unity (1± ) to be applied to Vs± (t, τ, τ ′ ) in (6), respectively. Note that the
expansion here is different than what is provided in [4]. This is due to the
fact that, here, the purpose is the fair valuation of the portfolio as opposed
to calculating the exposure. From (6) and (8)

Vs (t, τ, τ ′ ) = Vs+ (t, τ, τ ′ ) 1+ − Vs− (t, τ, τ ′ ) 1−

= Vs+ (t, τ, τ ′ ) [Iτ ′ <η .Iτ >τ ′ + Iτ ′ <η .Iτ <τ ′ + Iτ ′ >η ]
− Vs− (t, τ, τ ′ ) [Iτ <η .Iτ ′ >τ + Iτ <η .Iτ ′ <τ + Iτ >η ] (9)

The next expansion can be done on the recovery states (recover the recovery
amount or not) of both counterparties

Vs (t, τ, τ ′ ) =Vs+ (t, τ, τ ′ ) [Iτ ′ <η .Iτ >τ ′ (1 − R′ ) + Iτ ′ <η .Iτ >τ ′ R′ +
Iτ ′ <η .Iτ <τ ′ + Iτ ′ >η ]
−Vs− (t, τ, τ ′ ) [Iτ <η .Iτ ′ >τ (1 − R) + Iτ <η .Iτ ′ >τ R+
Iτ <η .Iτ ′ <τ + Iτ >η ] (10)

where R′ and R are the rates of recovery for the primed and unprimed
counterparties. As expected, the entire r.h.s of the above equation equals
Vs (t, τ, τ ′ ). Applying (4) to (10) and regrouping the terms allows one to
finally obtain the value of a portfolio conditional on both counterparties sur-
vival until t broken in the following compenents

10
 Vs (t, τ, τ ′ ) (11)

+ V + (t) Iτ >t Iτ ′ >t . [Iτ ′ <η .Iτ >τ ′ (1 − R′ )] (12)

− V − (t) Iτ >t Iτ ′ >t . [Iτ <η .Iτ ′ >τ (1 − R)] (13)

 
 
+ V + (t) Iτ >t Iτ ′ >t . Iτ ′ <η .Iτ >τ ′ R′ + Iτ ′ <η .Iτ <τ ′ + Iτ ′ >η  (14)
| {z } | {z } |{z}
(1) (2) (3)

 
 
− V − (t) Iτ >t Iτ ′ >t . Iτ <η .Iτ ′ >τ R + Iτ <η .Iτ ′ <τ + Iτ >η  (15)
| {z } | {z } |{z}
(1) (2) (3)

As defined during the course of this article, the positive cash flow represents
inflow (received) and negative cash flow represents outflow (paid).
Assuming the positive value to be the incoming cash flow to the unprimed6
counterparty, V + (t) Iτ >t Iτ ′ >t and V − (t) Iτ >t Iτ ′ >t would represent the surviv-
ing asset and liability to the unprimed counterparty, respectively. The fol-
lowing interpretation of the above terms, from the unprimed counterparty’s
view, can be made7 :
[11] Value of the portfolio without any counterparty risk considerations.
[12] Asset Charge: The portion, 1−R′ , of the asset not received if the primed
counterparty default first.
[13] Liability Benefit: The portion, 1−R, of the liability held if the unprimed
counterparty default first.
[14.1] A portion, R′ , of the asset received if the primed counterparty default
first.
[14.2] Total amount of the asset received if the unprimed default first.
[14.3] Total amount of the asset received if the primed counterparty do not
6
An easy, and perhaps crude, way to follow would also be to consider the unprimed
counterparty to be ”us” and the primed counterparty to be ”them”.
7
It is understood that the definitions are made on the path measured by the filtration
Ft as defined in (1).

11
default during the evaluation horizon.
[15.1] A portion, R, of the liability paid if the unprimed counterparty default
first.
[15.2] Total amount of the liability paid if the primed counterparty default
first.
[15.3] Total amount of the liability paid if the unprimed counterparty do not
default during the evaluation horizon.
One interpretation of the equations (12) through (15) can be the following:
the contributions to the value of the surviving portfolio, Vs (t, τ, τ ′ ) come
from two sources of loss [(12) and (13)] and recovery8 [(14) and (15)], of both
counterparties. Defining Vs∗ (t, τ, τ ′ ) to be the net total of recovery values of
all cash flows, between t and η, conditional on both counterparties surviving
until t,

Vs∗ (t, τ, τ ′ ) ≡
+V + (t) Iτ >t Iτ ′ >t . [Iτ ′ <η .Iτ >τ ′ R′ + Iτ ′ <η .Iτ <τ ′ + Iτ ′ >η ]

−V − (t) Iτ >t Iτ ′ >t . [Iτ <η .Iτ ′ >τ R + Iτ <η .Iτ ′ <τ + Iτ >η ] (16)

One can now define CVA as the adjustment to the surviving portfolio in or-
der to obtain the value of the portfolio with counterparty risk Vs∗ (t, τ, τ ′ ).

CVA(t, τ, τ ′ ) ≡Vs∗ (t, τ, τ ′ ) − Vs (t, τ, τ ′ ) (17)

= − V + (t) Iτ >t Iτ ′ >t . [Iτ ′ <η .Iτ >τ ′ (1 − R′ )] (18)

+ V − (t) Iτ >t Iτ ′ >t . [Iτ <η .Iτ ′ >τ (1 − R)] (19)

Equation (18) and (19) are the components of CVA conditional on the fil-
tration Ft . The term Vd (t, τ, τ ′ ) was omitted in the above equation for two
reasons. One reason is that CVA is based on the condition that both coun-
terparties survive until t, the time of evaluation. The second reason why it
was omitted is that the recovery was assumed realized at the time of default.
Should the recovery occur after the default event (which is usually the case),
then the defaulted portfolio,Vd (t, τ, τ ′ ), should be included in the model. In
8
Note that in the equations (14.2),(14.3),(15.2) and (15.3) the rate of recovery can be
interpreted as 100%.

12
cases where the default has occurred, the recovery may be in the future and
needs to be accounted for.

5.1 Derivation of Asset Charge

The more practical representation of the asset charge for the un-collateralized
portfolio is shown here. Starting from (12), define

ACu (t; τ, τ ′ ) ≡ V + (t) Iτ >t Iτ ′ >t . [Iτ ′ <η .Iτ >τ ′ (1 − R′ )] (20)

Equation (20) represents the stochastic value of asset charge for one single
continuous period between t and η as of time t. If the entire length of the
trade is divided into N number of evaluation horizons, each δt infinitesimally
long, with

i = 0, 1, 2, · · · , N − 1 (21)

[ ]
ACu (Ti |FTi ) ≡ E V + (Ti ) Iτ >Ti Iτ ′ >Ti .Iτ ′ <Ti+1 Iτ >τ ′ (1 − R′ ) |FTi (22)

would represent the asset charge contribution of each period measured at the
beginning of each period conditional on both counterparties surviving until
Ti . Incorporating the conditional survival,
[ ]
ACu (Ti |FTi ) = E V + (Ti ) Iτ ′ ∈(Ti ,Ti +δt] .Iτ >τ ′ (1 − R′ ) |FTi (23)

The unconditional expectation of the asset charge is

[ ]
ACu (Ti ) = B(0, Ti )E V + (Ti ) Iτ ′ ∈(Ti ,Ti +δt] .Iτ >τ ′ (1 − R′ ) (24)

where
E[.] ≡ E[.|F0 ] (25)

13
and (1) were used. Finally the total contribution, valued at time 0, is

∑
N −1
ACu = ACu (Ti )
i=0
∑
N −1
[ ]
= B(0, Ti )E V + (Ti ) Iτ ′ ∈(Ti ,Ti +δt] .Iτ >τ ′ (1 − R′ ) (26)
i=0

Assuming independence of the portfolio’s value to the probability of either

defaults
∑
N −1
ACu = ACu (Ti )
i=0
∑
N −1
[ ]
= B(0, Ti )V + (Ti ) E Iτ ′ ∈(Ti ,Ti +δt] .Iτ >τ ′ (1 − R′ ) (27)
i=0

Assuming a deterministic recovery of default

∑
N −1
ACu = ACu (Ti )
i=0
∑
N −1
[ ]
= B(0, Ti )V + (Ti ) (1 − R′ ) E Iτ ′ ∈(Ti ,Ti +δt] .Iτ >τ ′ (28)
i=0

The above equation is a summation of N integrals each from Ti to Ti+1 as δt

is still assumed to be infinitesimal. Assuming the independence between the
two defaults a modified and a commonly used expression can be obtained by
considering discrete times of defaults that fall on Ti s

∑
N −1
[ ]
′
ACu = (1 − R ) B(0, Ti )E V + (Ti ) [P ′ (Ti+1 ) − P ′ (Ti )] Q(Ti+1 ) (29)
i=0

with P and P ′ to be the cumulative probability of default for the unprimed

and primed counterparty, respectively. Note the consequence of survival
probability until the end of the period rather than until the default of the
primed counterparty, due to discrete default times. The cumulative survival
probability is obtained from

Q(t) = 1 − P (t) (30)

14
and
Q′ (t) = 1 − P ′ (t) . (31)
Having established (22), since one party’s asset charge is the liability benefit
of another, the calculation for the liability benefit is only a matter of exercise.

5.2 Derivation of Liability Benefit

In the above section, starting from (12), the asset charge term was derived.
From (13) the same method can be applied in order to obtain the liability
benefit
∑
N −1
LBu = LBu (Ti )
i=0
∑
N −1
[ ]
= B(0, Ti )E V − (Ti ) Iτ ∈(Ti ,Ti +δt] .Iτ ′ >τ (1 − R) (32)
i=0

Given the same assumptions, as in the case of the asset charge, a simpler
description for Liability Charge can be obtained

∑
N −1
[ ]
LBu = (1 − R) B(0, Ti )E V − (Ti ) [P (Ti+1 ) − P (Ti )] Q′ (Ti+1 ) (33)
i=0

Equation (32) represents the liability benefit of the unprimed counterparty

to the primed counterparty. Note that switching the prime and unprime
sign and changing the sign of (33) one obtains (22). In simple terms, one
counterparty’s asset charge, is another counterparty’s liability benefit.

5.3 A Toy Example: Liability Benefit in an Un-collateralized

Account
To get a better sense of what has been achieved so far, consider the case of
a LIBOR entity, with 5% hazard rate (λ) selling an nontransferable $1,000
bullet bond, maturing in one year, to a sub-LIBOR entity with 10% hazard
rate (λ′ ). Without the loss of generality, one can assume the interest rate and
the rate of recovery of zero for both counterparties. Though such an example
is an over simplification, as a toy example, it provides the basic building block
and the ground work for more complicated and realistic situations. Within
the context of the example, one can now ask the following question: Given a

15
mark to market of, say $1,000, what is the liability benefit that the LIBOR
entity should be stating?
For further calculations, N = 1, B(0, 0) = $1, R = R′ = 0, V − (0) = −$1, 000
and δt = 1. Using the hazard rates provided above, different calculations for
the 1-year horizon is given. From (33)

∑
N −1
[ ]
LBu = (1 − R) B(0, Ti )E V − (Ti ) [P (Ti+1 ) − P (Ti )] Q′ (Ti+1 )
i=0
[( ) ] ′
= −$1, 000 × 1 − e−λ×1 − 0 × e−λ ×1
∼
= −$44.13 (34)

On the hand, using (32),

[ ]
LBu = E −$1, 000 × Iτ ∈(0,1] .Iτ ′ >τ
∫ ∫
= −$1, 000 × dP(τ, τ ′ )Iτ ∈(0,1] .Iτ ′ >τ (35)
τ′ τ

Assuming independence between τ and τ ′

∫ ∫
LBu = −$1, 000 × dP (τ )dP ′ (τ ′ )Iτ ∈(0,1] .Iτ ′ >τ
′
∫τ 1 ∫τ ∞
= −$1, 000 × dP (τ )dP ′ (τ ′ )
∫0 1 ∫τ ∞
= −$1, 000 × λ exp (−λt) dtλ′ exp (−λ′ t′ ) dt′
0 τ
∫ 1
′
= −$1, 000 × λ e−(λ+λ )t dt
0
λ ( )
−(λ+λ′ )×1
= −$1, 000 × 1 − e
(λ + λ′ )
∼
= −$46.43 (36)

6 Decomposition of a Collateralized Portfolio

In the case of un-collateralized portfolio, the amount at risk was the market
value of the portfolio. The counterparty with the positive value had the posi-
tive exposure to the defaulting counterparty. In the case of the collateralized
portfolio, the exposure is reduced due to the collateral. Among other issues, a
collateral arrangement also defines the margining period which theoretically

16
sets a fixed schedule on which applicable collateral can be called. The risk,
conditional on both counterparties surviving until the last margin call date,
would be the excess of the portfolio value over the collateral held due the
most recent collateral call. The simplest approach to collateralized exposure
is to look at the collateral process separate from the portfolio value. In this
method the most effort is focused on the simulation of the collateral. To
start with, the collateralized portfolio can be offset by the collateral amount
as

Vs (t, τ, τ ′ ) ≡ {V (t) − C(tc )G(tc , t))} [Iτ ′ >t .Iτ >t ]

= Vs+ (t, τ, τ ′ ) 1+ − Vs− (t, τ, τ ′ ) 1− (37)

where tc belongs to the last collateral call prior to t. The amount C(tc ) is the
collateral received (+) or posted (-) at tc . The factor G(tc , t) is the growth
factor active from the last collateral call until t. It is usually pre defined in
CSA as to how it is calculated. In most cases it is based on overnight rate.
Once the portfolio value is adjusted by the collateral, the treatment of the
decomposition of this portfolio follows naturally in the same manner as the
un-collateralized portfolio. Practically, the main portion of the counterparty
risk modeling of a collateralized portfolio is the modeling of the collateral
process which strongly depends on how much sophistication is required. To
incorporate the threshold level with no minimum transfer amount, the col-
lateral from the unprimed counterparty’s view can be modeled as

C(tc ) = (V (tc ) − Dr′ )+ − (V (tc ) − Dr )+ (38)

where the thresholds Dr′ and Dr correspond to the primed and the unprimed
counterparties, respectively, and are always positive. To model the unilat-
eral agreement simply assign infinity to Dr′ (primed counterparty calls only)
or Dr (unprimed counterparty calls only). The sub-index r represents the
dependence of the threshold to the rating of the counterparties; a common
schedule in CSA agreement. Note that the above equation does not depend
on τ nor τ ′ . This is to reflect the collection of collateral conditional on both
counterparties surviving. Readers should note that tc is the last call date
prior to t. In most cases V (tc ) is simply interpolated. The definition of the
collateral given in (38) is different from what is given in [6] since here both
terms are given to reflect the fair value and not just the exposure.
One can modify the above equation to include the minimum transfer amount

17
and obtain

(V (tc ) − (Dr′ + m))+

C(tc ) = (V (tc ) − (Dr′ ))
(V (tc ) − (Dr′ + m))
(V (tc ) − (Dr + m))+
− (V (tc ) − (Dr )) (39)
(V (tc ) − (Dr + m))

Obviously, there is no end as to how far the sophistication of the collateral

modeling can reach. Margin periods vary in range starting from one day
(daily margin) to six months (semi-annual) with daily margin being the most
common. While the grace period depends on the regional governing law and
it is about two to three business days.
The remaining challenge is to properly calculate the collateral during the
life of the portfolio as measured by FTi conditional on both survivals. Note
that the calculation of the exposure on every margin day is challenging if
not impossible. A common practice is to select a set of horizon times that is
dense at the beginning and coarse at far horizons. Value of the portfolio at
both or either time horizons can then be interpolated using an appropriate
interpolation scheme.
To give a flavor of the process, one can follow the following steps: break
the entire time life of the portfolio in to discrete time points Ti . For every
time horizon Ti calculate V (Ti ). Interpolate V (tc ) from V (Ti ) and V (Ti−1 ).
Calculate C(tc ) in (39) and replace it, along with V (Ti ), in (37) and use (12)
through (15) and the subsequent equations to calculate the CVA. In cases
where Ti is smaller than the margin period, tc = 0. That is, C(0) is the
collateral currently held/posted.

6.1 A Toy Example: Calculation of Exposure in A Col-

lateralized Account
To get an intuition around collateralized exposure a scenario analysis is given
here where the interest rate on cash deposits, threshold level and minimum
transfer amount are 0 and there has not been any need for collateral trans-
fer. Assume that at time t0 the value of the portfolio is +1 to the unprimed
counterparty. The unprimed counterparty’s exposure at time t0 is, therefore,
+1. Further more, assume that immediately after the evaluation at t0 , a
collateral transfer of +1 is made from the primed counterparty. During the
next margin period, within the scope of this scenario, the market moves in
such a way that the portfolio is valued at −1 to the unprimed counterparty

18
and +1 to the primed counterparty (due to some cashflow movement). So
far, the total collateral collected by the primed counterparty is −1 (since it
has already paid the collateral during the past period) with the value of the
portfolio now at +1, the primed counterparty’s exposure is now +2.
One important point from the above illustration is the strong dependency of
the exposure on the path of the scenario. The next concept to note is that
the final spot exposure, +2, was more than the spot value of the portfolio,
+1, to the primed counterparty. This differential at risk is commonly called
collateral call-back risk. It points to the collateral that the primed counter-
party had with the unprimed counterparty that could be lost, and not be
“called back”, due to the primed counterparty’s default.

6.2 Remaining Risks in Current Collateralized Arrange-

ments
The example in the previous section underlines two important elements of
the collateralized relationship which are often overlooked. The first element
is that in such a relationship two types of payments take place. One type of
payment is due to trade payoff which can happen any time according to the
trade specification. Another, is the payment due to collateral payable under
the collateral agreement on collateral call dates only. The second important
element is that the collateral payment lags behind on covering the exposure.
These two elements can be a very risky combination. Imagine the case where
a large payment is due to the client based on some trade payoff, such as a
payment of an FX swap, today. The dealer is not entitled to offset the
payment with the up − coming required collateral. The dealer has to transfer
the payment first and wait until the next immediate call date (at the closest,
the next day) in order to get the collateral amount. For as long as the dealer
is waiting for the call date and arrival of the collateral, it has undoubtedly
an unsecured risk against this client. The probability of the client defaulting
on the next day after the trade payment seems small, initially. However,
incentive of a defaulting client to survive until the payment is received is
directly proportional to the amount of the payment. That is, the client would
continue to pay the collateral payments (albeit difficult) to avoid default,
receive the long-awaited payment, then default on collateral payment and use
the proceedings from the payment for restructuring or to increase the recovery
rate of its bond holders. The larger the payment, the less the probability of
client’s default would be continuous over the payment date. Many dealers
reason, based on their existing ongoing monitoring of their clients’ credit

19
health, that they would withhold payments to those with deteriorating credit.
Unfortunately, this argument could only be true for some clients (such those
of publicly trading entities where there are usually more information available
in the market place) and does not always apply to highly leveraged and
secretive clients like hedge funds.

7 Counterparty Risk and Counterparty Trad-

ing
All the calculations regarding the risk management of an existing portfolio,
mentioned in this article, are essential. However, the most important risk
management strategy is one that signals before entering into an unwanted
trade. Therefore, the first line of defence is the in-depth knowledge of the
counterparties’ credit status. The next relevant risk mitigant, equally im-
portant, is a strongly binding legal documentation governing the trading
relationship. All major dealers, and trading firms, have a legal and a su-
pervisory department with the objective of counterparty risk analysis where
credit health and the firm’s ongoing exposures to each of its counterparties is
analyzed. Each trade, through different mechanism, is then passed through
an approval process by this department. This process makes the dynamics
of the counterparty risk management a prior-to-trade activity and minimizes
the possibility of entering into an excessively risky trade with an unwarranted
counterparty. In reality, however, a trade needs to be done and the risk needs
to be taken for the simple reason that the dealers are in the business of taking
appropriate risks for the appropriate rewards. In such cases the extinguish-
ing trades, with the strongly legally binding documentation, should be the
most important risk management strategy. An “extinguisher” trade is one
that extinguishes (cancels) once an event, most commonly a credit event,
happens. An “extinguisher” trade with a credit trigger, such as credit rat-
ing drop, well defined inside each trade confirm, reduces the burden of the
credit management of a trading portfolio to a difficult counterparty. This is
particularly very suitable for counterparties where the probability of default
is very difficult to measure. However, based on the same token, pricing of
these trades would remain a challenge and is usually reflected in the spread
of the trade.
Where there is risk of loss, there is also the possibility of reward. Roughly
speaking, both components of CVA can be monetized by entering into other
trades where the option-to-default is cashed-in through upfront premium or
higher spread levels [7].

20
Most trading firms with large counterparty exposures have now a unit with
a mandate of monetizing the profit opportunities arising from counterparty
credit risk. The desk, in general, acts as a separate dealer providing the CVA
risk management for different desks for a fee. In another simple form, it can
purchase the asset charge from different desks, with initial profit and manage
the exposure thereafter. The desks, on the other hand, are also willing to
trade away the credit risk in order to lower their counterparty exposure for
further trading opportunities.
To get an intuition around monetizing CVA components, consider the ex-
ample provided in section 4. In order for the sub-LIBOR counterparty to
monetize its liability benefit, it can enter into a back-to-back trade with a
new LIBOR counterparty, highly correlated with the initial LIBOR counter-
party, where it receives the same positive cash flow. However, this trade can
have a provision to provide an option to this new counterparty to cancel the
trade in case the sub-LIBOR counterparty defaults. This option will worth
the same amount as the liability benefit that was received from the original
trade.
In reality, the trade provided in section 4 does not easily happen as the
original LIBOR quality dealer, who was penalized the asset charge, had no
incentive to enter into the trade. However, in more involved transactions
liability benefit opportunities are present and need to be monetized.

8 Summary
A basic and introductory review of counterparty valuation adjustment was
given. The components to the CVA were derived by decomposing the port-
folio’s value into a set of binary states.
The application of the formulae depends strongly on the assumptions, sophis-
tication of the simulation and the goodness of the input values. Practically
speaking, CVA calculations end up to be crude, mostly due to the lack of
proper input values. Except a number of entities, there are not many tradable
securities, such as credit default swaps (CDS), reflecting the market’s view on
credit health of the counterparties. Even when there are such instruments,
there is usually a lack of market implied volatilities for them. Another impor-
tant issue is the interdependence of the processes involved which is usually
omitted all together due to insufficient market implied correlation factors.
It is important to note that the discussion in this article was based on a sin-
gle portfolio. However, in reality, there are as many portfolios, on a dealer’s
book, as there are active counterparties. Once the error is introduced for a

21
single portfolio due to lack of proper input value, the accumulation of the
errors and the interdependence of the portfolios is still to be tackled.
These mentioned issues are real and do cost dealers and trading firms. How-
ever, the purpose of itemizing them here is to encourage and motivate the
readers for future work and to represent opportunities for further develop-
ments.

9 Acknowledgements
Authors are grateful to Alfredo Bequillard for constructive comments and
Fong Liu for his continuous support.

References
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[2] Michael Pykhtin, Counterparty Credit Risk Modelling: Risk Manage-

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[3] Paul C. Harding, Mastering the ISDA Master Agreements, FT. Pren-
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[4] Damiano Brigo and Fabio Mercurio, Interest Rate Models - Theory and
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[5] Eduardo Canabarro and Darrell duffie, Chapter 9: Measuring and

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[6] Michael S. Gibson. Measuring Counterparty Credit Exposure to a

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[7] Yi Tang and Bin Li. Quantitative Analysis, Derivative Modeling and
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22