Toronto, December 15^th, 2010.

A new paper by Michael Pykhtin of the FRB and Dan Rosen, CEO of R², published in the Winter 2011 issue of the Journal of Credit Risk, proposes a novel methodology for allocating counterparty-level credit valuation adjustment (CVA) to individual trades.

CVA must be priced at the counterparty level. However, it is desirable for risk management purposes to determine the contributions of individual trades to the counterparty-level CVA. In this sense, the problem of calculating CVA contributions bears many similarities to the calculation of risk contributions and capital allocation. The authors show how to define and calculate marginal CVA contributions in the presence of netting and margin agreements, and under a wide range of assumptions, including wrong-way risk – the dependence of exposure on the counterparty’s credit quality. These allocations are additive, so that one can aggregate the CVA allocations for any collection of trades with different counterparties. Thus, the contribution of all trades belonging to a certain class of the bank-level CVA can be calculated. Such a class can be defined as “all trades booked by a certain business unit”, “all EUR interest rate swaptions”, etc. The calculation of CVA contributions can be easily incorporated into exposure simulation processes, and the authors also derive closed-form expressions when the trade values are normally distributed.

For more information on R² research and solutions for CVA and Basel III counterparty credit risk capital, please contact marketing@R2-financial.com.