Credit Vae Adjstment (CVA) is te amont sbtractedrom te mark-to-market (MTM) vae o derivativepositions to accont or te expected oss de toconterpart deats. Debt Vae Adjstment (DVA)is basica CVA rom te conterpart’s perspective. Ione part incrs a CVA oss, te oter part records acorresponding DVA gain.
DVA is the amount added back to the MTM value toaccount or the expected gain rom an institution’s owndeault. Including DVA (in addition to CVA) is intuitivelypleasing because both parties theoretically report thesame credit-adjusted MTM value. DVA is also controversialbecause institutions record gains when their credit qualitydeteriorates, creating perverse incentives, and the gainscan only be realised on deault
Accounting rules mandate the inclusion o CVA in MTMreporting, which means bank earnings are subject toCVA volatility. DVA is also accepted under the accountingrules and banks that include it, and by doing so mustcontinue to include it going orward, add their own creditspread as a source o earnings volatility. To mitigate CVAvolatility, as well as hedge deault risk, many banks buyCDS protection on their counterparties. Hedging DVA isnot as straightorward. Since DVA increases as the bank’scredit spread widens, it is equivalent to the bank beingshort its own debt. Thereore, hedging involves buyingthe bank’s own bonds or selling protection on highlycorrelated institutions, i.e., other banks, since they can’t sellprotection on themselves.DVA became a hot topic when banks announced 2011Q3 earnings, due to the magnitude and direction o theamounts. Ironically, where large DVA gains substantiallyimpacted earnings, the bank’s outlook improved,thereby tightening its credit spread and generating DVAlosses. This article is a sequel to a previous reportentitled ‘CVA, DVA and Bank Earnings’, which attemptedto dissect the Q3 DVA results and make some predictionsabout Q4. Here, we will analyze the recently reported Q4DVA results.
Q3 DVA Review
Most banks reported large DVA gains or the third quarterdue to signicantly wider credit spreads. The ollowingtable displays Q3 DVA results reported by the ve largestU.S. banks:
BankJn CDS(bps)Sep CDS∆ CDSDVA Gain(bn)BAC
Q4 DVA Rests
We used the reported Q3 DVA results above to estimate Q4DVAs. These estimates, along with the actual change in CDSspreads during Q4 are provided in the ollowing table:
BankSep CDSDec CDS∆ CDSEst. DVAGain (mm)BAC
Drector o Credt ad
Drector o Reearch, at Quatf
CVA, DVA AnD Q4BAnk EARnings