Variable Exposure Approach

Formula: 

Cva cds

 

This approach estimates CVA as the hypothetical cost to purchase credit protection, depending on the forecast exposure of the derivative.

Forecasting does not require simulation as it is based on the assumption that markets evolve according to current forward/futures prices.

Therefore, volatility of market variables is not taken into account.

At each CF date of the derivative, the fair value of the remaining CFs is calculated.

The variable exposure approach then sums the costs of buying CDS protection for the future exposure between consecutive CF dates.

Example: if the payment frequency of the derivative is quarterly, the maturity of each CDS would be 3 months. 

 

Terms: 

CDSt = CDS with a notional principal equal to the PV of the remaining CFs of the derivative at time t.

In case the PV of the remaining CFs at a time point is a liability, own credit spreads are used to value the default leg of the CDS.

Otherwise, credit spreads of the counterparty are used. The PV of the premium leg is used for calculating CVA. 

Advantages:

- methodology takes both current and future exposure into account 

- considers bilateral nature of derivatives 

- can be applied on transactional level or 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


 

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