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AMST ERDAM | BR USSELS | EDINBURGH | FR ANKF URT | LONDON | L UXEMBOUR G | MIL AN

Credit Value Adjustment
(CVA): The Standardised
Method

Frederic Gielen,
Partner
Avantage Reply

Ilya Kraev,
Senior Consultant
Avantage Reply

Introduction
The CVA of an OTC derivatives portfolio with a given
counterparty is the market value of the credit risk due
to any failure to perform on agreements with that
counterparty4.
Basel 3 and the proposed CRD 4 require credit
institutions to calculate capital requirements for CVA for
all OTC derivative instruments in respect of all of
business activities, other than credit derivatives
intended to mitigate the risk-weighted exposure
amounts for credit risk.
Transactions with central counterparties (“CCPs”) are
excluded from the capital requirements for CVA risk.
Securities Financing Transactions (“SFTs”)—for example
repos—are excluded in the calculation of capital
requirements for CVA risk, unless the regulator
determines that the institution's CVA risk exposures
arising from those transactions are material.

The Standardised Method
Regulatory Formula

R

apid and continuous growth of the
OTC derivatives market with a
volume of over USD600 trillion as of
year end 20101 and the significance
of losses due to counterparty
default in such contracts caused
regulators to introduce new regulation requiring
additional capital with respect to counterparty
risk.
In a discussion paper dated April 2010,2 the FSA
analysed the losses related to different types of
assets
and
concluded
that
two-thirds
of
counterparty credit risk losses were attributable
to Credit Valuation Adjustment (“CVA”) and only
about one-third were due to actual counterparty
defaults.
The CVA capital requirements introduced by Basel
3 (and its European version, the proposed CRD 4)
seek to ensure that credit institutions hold capital
to mitigate the credit risk losses attributable to
CVA.
There are two methodologies for calculating the
capital requirements for CVA, the Advanced
Method and the Standardised Method.

Institutions using the Standardised Method must
calculate the capital requirements for CVA risk in
accordance with the following:4
where:

h is a one-year time horizon, i.e. h=1;

2

3

Banks for International Settlements, OTC
derivatives markets activity in the second half of
2010, May 2011.
Financial Services Authority, The prudential regime
for trading activities – A fundamental review,
August 2010.
The Advanced Method requires the institution to
have Internal Model Method (“IMM”) approval for

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wi is the (risk) weight of the counterparty. It
ranges from 0.7% to 10% depending on the
credit quality of the counterparty;

EADi and Mi represent the (discounted)
exposure at default of Counterparty ‘i’
(including the effect of credit risk mitigation)
and the effective maturity of the transactions
with Counterparty ‘i’.5

In this Practice Note we will assume that CVA is not
hedged and hence will not make reference to other
elements included in the standard formula above.
There are several steps to be performed to calculate
the capital requirements for CVA risk:

The first is to calculate the (discounted)
exposure at default and effective maturity of
the transactions across the netting sets with
the counterparty;

In this practice note, we explain what CVA is, how
it is measured under the Standardised Method
and the key drivers that impact the amount of
regulatory capital required for CVA.3

1

4

5

The second step is to assign the appropriate
weight to the counterparty. The weight is

Counterparty Credit Risk (“CCR”) and internal model
approval for the specific risk of debt instruments. In
December, Avantage Reply will issue a Practice Note
reviewing some specific issues relating to CVA under
the Advanced Method.
For a detailed review of the formula, please refer to
Basel 3 (Paragraph 104) and CRD 4 (Article 374).
It is noted that there is a difference between the
version of Basel 3 published in June 2011 and CRD
4. Whereas CRD 4 currently maintains a five-year
cap for the Maturity, this cap has been removed in
the June revision of Basel 3.

and/or (iii) use CCPs for clearing purposes. we assume that these are the only two transactions entered into by Bank ‘Y’. It is noted that 1% is the standard percentage applied to the notional of a forward foreign currency contract with a maturity of 12 months or less to determine its potential future exposure under the mark-to-market method. Parent Rating = AA- Forward exchange contracts Maturity = 6 months Bank’s Functional CCY: EUR €10 mio $14 mio BANK ‘Y’ €10 mio Figure 1: Simplified Illustration Step 1 – Calculating EADi and Mi Assuming that Bank Y determines the exposure at default for OTC derivatives by reference to the CCR mark-to-market method. AAA to AA-) the CVA (risk) weight is 0. The CCR and CVA capital requirement will evolve over time as the exposure at default9 and effective maturity vary. For the highest credit rating grade (i. and  Parent = EUR 100. The understanding of these key drivers can help credit institutions to evaluate the materiality of the impact of the CVA risk capital requirement based on their existing portfolios of OTC derivatives and product offering.000 * 20% * 8% = 1.600. The additional capital requirement arising from CVA on 01 November 201X risk is calculated by reference to the above formula and amounts to EUR 1. 8 9 The calculation assumes that Bank Y uses the Standardised credit risk approach under Basel 2/CRD whereby the respective risk weights based on the applicable external credit ratings are 50% and 20%. respectively.e.600.000 * 50% * 8% = EUR 4.000 EUR 10mm x 1% = EUR 100. Because Company ‘X’ has a credit rating of ‘A-’.366. Drivers of the Capital Requirement for CVA Risk $14 mio COMPANY ‘X’ Rating = A- whereas the Parent has a rating of ‘AA-’. Counterparty Credit Rating The counterparty credit rating determines the (risk) weight for the CVA calculation. 6 Illustration On 1 November 201X. EAD) is EUR 81mm. the weight is based on the counterparty’s external credit rating. To illustrate the impact of counterparty credit rating on the capital requirement for CVA risk..e. Exposure at default will vary over time as a result of changes in the mark-to-market value of the transactions and the related potential future exposures. to hedge its foreign currency risk.e.e. EADi is calculated as follows: EADi EADCorporate X EADParent Amount (in EUR) EUR 10mm x 1%7 = EUR 100. Step 2 – Calculating wi As noted above. Bank Y sells USD 14 million and buys EUR 10 million forward. It also assumes that Bank Y is subject to an 8% capital adequacy ratio requirement.000. we assume that Bank Y has a trading portfolio consisting of eight foreign exchange forward transactions with eight distinct counterparties. The resulting total exposure (i. a weight of 0.7%. we will examine some of the key drivers of the capital requirement for CVA risk. Step 3 – Calculating the Capital Requirement for CVA Risk and Credit Counterparty Risk (CCR) For illustration’s purposes. it increases to 10% for counterparties with a credit rating of CCC and below.:8  Company X = EUR 100. In the paragraphs that follow..AMST ERDAM | BR USSELS | EDINBURGH | FR ANKF URT | LONDON | L UXEMBOUR G | MIL AN based on the counterparty’s external credit rating.e. The effective maturity of both foreign exchange transactions is six months when Bank Y enters into them on 1 November 201X. i. (ii) adopt hedging strategies. i. Each transaction has an effective maturity of three months.000 The (discounted) exposure at default is then calculated by applying a standardised discounting factor based on the maturity of the transaction. Company X (a large corporate) enters into a 6-month foreign exchange contract (selling USD 14 million and buying EUR 10 million) with Bank Y. the capital requirement for CCR (as exists under the current Basel 2 and CRD requirements) is EUR 5. It can also help them in evaluating the need to: (i) review their portfolios and product offering. CVA risk requires an additional 25% capital requirement as compared to the counterparty credit risk capital requirement under Basel 2/CRD. In the simplistic example above.8% 6 7 On 1 November 201X.7%. Avantage Reply | Credit Value Adjustment (CVA): The Standardised Method Page 2 . Bank Y enters into a back-to-back transaction with its Parent on the same day. i. and  The final step is to calculate the capital requirement for CVA risk. its weight is 0.

It should be noted that unrated counterparties are treated as BBB rated counterparties.5 4 3.500 15% 1. 15% 10% 5% 0% 1 2 3 4 5 6 7 8 9 10 11 12 Maturity. the capital requirement for CVA grows linearly. months Figure 3: CVA as a function of Maturity (1 to 12 months) 0% AAA AA A BBB BB B CCC Credit rating grade Figure 2: CVA as a function of External Ratings The figures below examine how the capital requirement for CVA risk (blue bars) evolves as the effective maturity varies between 1 and 12 months (figure 3). ceteris paribus.(maturity > 5 years ) CVA. we assume that Bank Y has a trading portfolio resulting in a total exposure of EUR 81mm. We assume that all counterparties have an external rating of BBB (i. EUR x 1000 CVA (1 year < maturity ≤ 5 years ) 500 140% 135% 130% 125% 120% 61 62 63 64 65 66 67 68 69 70 71 72 Maturity.10 The red line represents the increase in the capital requirement resulting from the CVA risk by comparison to the existing CCR capital requirement under Basel 2/CRD (expressed as a percentage).000 20% 1.5 2 1.e. 10 Under this simplified example. Avantage Reply | Credit Value Adjustment (CVA): The Standardised Method Page 3 . To illustrate this relationship. wi = 1%) and the effective maturity of the transactions is three months (Mi = 0. 11 It is noted that beyond 72 months. the relationship between the degree of concentration within their portfolio and the relative impact of CVA risk.000 10% CVA/CCR CVA.5 3 2. and To illustrate the impact of the effective maturity on the capital requirement for CVA risk.000 30% CVA/CCR 2.25). 100 40 It is clear that the capital requirement for CVA risk particularly penalises credit institutions that work with less credit worthy counterparties and that on a marginal basis there is a disproportionally larger CVA increase over the corresponding CCR capital requirement for poorly rated counterparties. 13 and 60 months (figure 4). and 60 to 72 months (figure 4).5 1 0. Portfolio Concentration A further driver is sometimes overlooked by credit institutions.500 25% 2. EUR x 1000 35% CVA 3.e. 120% 20 Effective Maturity of the Transactions It generally has a direct and indirect impact on the exposure at default (EADi) since the effective maturity is a significant driver in the calculation of the potential future exposure and impacts the discounting factor used in calculating the discounted EAD. EUR x 1000 The effective maturity of the transactions with a counterparty impacts the capital requirement at two levels:  First. months Figure 5: CVA as a function of Maturity (60 to 72 months) 11 It is clear that the capital requirement for CVA risk particularly penalises credit institutions that offer longdated OTC derivatives to their clients. we assume that Bank Y has a trading portfolio consisting of one foreign exchange forward transaction with one counterparty (notional = EUR 20mm). all eight counterparties are assumed to have the same external credit rating. it directly impacts the calculation as it is a factor (Mi) included in the regulatory formula. The red line represents the increase in the capital requirement resulting from the CVA risk by comparison to the existing CCR capital requirement under Basel 2/CRD (expressed as a percentage). months Figure 4: CVA as a function of Maturity (13 to 60 months) CVA .AMST ERDAM | BR USSELS | EDINBURGH | FR ANKF URT | LONDON | L UXEMBOUR G | MIL AN CVA. i.5 0 30% 25% 20% CVA/CCR CVA (maturiy ≤ 1 year) The figure below examines how the capital requirement for CVA risk (blue bars) evolves based on the external credit rating of the counterparties. EUR x 1000 3.500 5 4.  140% CVA/CCR - 120 185 180 175 170 165 160 155 150 145 140 155% 150% 145% CVA/CCR 5% CVA. ceteris paribus. 100% 80 80% 60 60% 40% 20% 0 0% 13 16 19 22 25 28 31 34 37 40 43 46 49 52 55 58 Maturity.

e.eu Ilya Kraev Senior Consultant Avantage Reply 149/24 Avenue Loiuse | Brussels 1050 Tel: +32 2 535 7442 E-mail: i.kraev@reply. While this Practice Note uses simplistic examples. is equally distributed amongst the counterparties). EUR x 1000 The figure below examines how the capital requirement for CVA risk (blue bars) evolves as the number of counterparties included in the portfolio increases (assuming that the total portfolio exposure. i.AMST ERDAM | BR USSELS | EDINBURGH | FR ANKF URT | LONDON | L UXEMBOUR G | MIL AN 500 8% CVA 450 CVA/CCR 400 7% 6% 350 300 5% 250 4% 200 3% 150 CVA/CCR CVA.eu Avantage Reply | Credit Value Adjustment (CVA): The Standardised Method Page 4 .gielen@reply. The red line represents the increase in the capital requirement resulting from the CVA risk by comparison to the existing CCR capital requirement under Basel 2/CRD (expressed as a percentage). the overall conclusions remain valid where institutions use more sophisticated models to calculate counterparty credit risk exposures and CVA risk. November 2011 Contact Frederic Gielen Partner Avantage Reply 5th Floor | Dukes House | 32-38 Dukes Place | London EC3A 7LP Tel: +44 20 7709 4000 E-mail: f. 2% 100 1% 50 0 0% 1 5 9 13 17 21 25 29 33 37 41 45 49 Number of counterparties Figure 6: CVA as a function of Concentration Conclusions The introduction of the CVA capital requirement under Basel 3 and CRD 4 will significantly increase the total capital requirement for credit institutions offering OTC derivatives. EUR 81mm.