Credit Value Adjustment - Explained

Abstract

Until 2008, OTC derivatives focussed on market risk. Counterparty risk was considered secondary. Most counterparties had strong credit rating and the possibility of default was seen as remote. While Basel-II introduced a capital charge for counterparty risk in the trading book and accounting rules introduced in 2006 required counterparty risk to be factored into balance sheet valuations, it continued to be managed at PFE (Potential Future Exposure) level. Derivatives were valued using the concepts of risk neutral probabilities and no arbitrage. A risk neutral portfolio is expected to earn a risk-free rate and LIBOR rates were the benchmark. The “risk-neutral” or “risk free” price assumed a credit risk free world – where none of the counterparties would default and all contractual cash flows will happen