Constant Exposure Approach

Formula: 

Cva cds

 

This approach is a simplification of the variable exposure approach, as the notional amount of each CDS is based on the current fair value of the derivative plus an add-on profile.

This add-on profile is: 

- a proxy for the potential future exposure of the derivative.

- computed in advance for a series of representative theoretical trades of standard maturities. 

 

Terms: 

CDSt = CDS with a notional principal equal to the current fair value plus the add-on (delta) profile at time t.

CVA is calculated as the PV of the premium legs of this series of CDS.

For CVA, counterparty credit spreads are utilised to value the default leg of the CDS, while for DVA own credit spreads are used. 

 

Advantages:

- can be applied on transactional level or counterparty level, as add-on profiles can also be calculated on counterparty level 

- Market-observable CDS spreads are directly used for CDS pricing, not requiring assumptions to convert to PD

- intuitive appeal as the CVA is the cost of purchasing credit protection

 

Disadvantages: 

- Does not account for potential future exposure, as it does not consider any variability of market variables that influence derivative fair value 

- The approach without add-on profiles does not account for potential future exposure at all 

- Does not consider bilateral nature of derivatives (ex: only considers counterparty credit risk for derivative assets and own credit risk for derivative liabilities, over the life of the derivative) 

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