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Credit Value Adjustment(CVA): The StandardisedMethod

apid and continuous growth of theOTC derivatives market with avolume of over USD600 trillion as ofyear end 20101 and the significanceof losses due to counterpartydefault in such contracts caused

regulators to introduce  new regulation requiringadditional capital with respect to counterpartyrisk.

In a discussion paper dated April 2010,2 the FSAanalysed the losses related to different types ofassets and concluded that two-thirds ofcounterparty credit risk losses were attributableto Credit Valuation Adjustment (“CVA”)  and onlyabout one-third were due to actual counterpartydefaults.

The CVA capital requirements introduced by Basel3 (and its European version, the proposed CRD 4)seek to ensure that credit institutions hold capitalto mitigate the credit risk losses attributable toCVA.

There are two methodologies for calculating the

capital requirements for CVA, the AdvancedMethod and the Standardised Method.

In this practice note, we explain what CVA is, howit is measured under the Standardised Methodand the key drivers that impact the amount ofregulatory capital required for CVA.3 

1  Banks for International Settlements, OTC

derivatives markets activity in the second half of2010, May 2011.

2  Financial Services Authority, The prudential regimefor trading activities – A fundamental review ,August 2010.

3  The Advanced Method requires the institution tohave Internal Model Method (“IMM”) approval for

Introduction

The CVA of an OTC derivatives portfolio with a givencounterparty is the market value of the credit risk dueto any failure to perform on agreements with thatcounterparty4.

Basel 3 and the proposed CRD 4 require creditinstitutions to calculate capital requirements for CVA forall OTC derivative instruments in respect of all ofbusiness activities, other than credit derivativesintended to mitigate the risk-weighted exposureamounts for credit risk.

Transactions with central counterparties (“CCPs”) areexcluded from the capital requirements for CVA risk.Securities Financing Transactions ( “SFTs” )—for examplerepos—are excluded in the calculation of capitalrequirements for CVA risk, unless the regulatordetermines that the institution's CVA risk exposuresarising from those transactions are material.

The Standardised Method

Regulatory Form ula

Institutions using the Standardised Method mustcalculate the capital requirements for CVA risk inaccordance with the following:4 

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

  w i  is the (risk) weight of the counterparty. Itranges from 0.7% to 10% depending on thecredit quality of the counterparty;

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

In this Practice Note we will assume that CVA is nothedged and hence will not make reference to otherelements included in the standard formula above.

There are several steps to be performed to calculatethe capital requirements for CVA risk:

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

the counterparty;

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

Counterparty Credit Risk (“CCR”) and internal modelapproval for the specific risk of debt instruments. InDecember, Avantage Reply will issue a Practice Notereviewing some specific issues relating to CVA underthe Advanced Method.

4  For a detailed review of the formula, please refer toBasel 3 (Paragraph 104) and CRD 4 (Article 374).

5  It is noted that there is a difference between theversion of Basel 3 published in June 2011 and CRD4. Whereas CRD 4 currently maintains a five-year

cap for the Maturity, this cap has been removed inthe June revision of Basel 3. 

Frederic Gielen,

Partner

Avantage Reply 

Ilya Kraev,

Senior Consultant

Avantage Reply 

R

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based on the counterparty’s external creditrating; and

  The final step is to calculate the capital

requirement for CVA risk.

I l lustrat ion 6  

On 1 November 201X, Company X (a large corporate)enters into a 6-month foreign exchange contract(selling USD 14 million and buying EUR 10 million) withBank Y, to hedge its foreign currency risk.

Bank Y enters into a back-to-back transaction with itsParent on the same day, i.e. Bank Y sells USD 14million and buys EUR 10 million forward.

Figure 1: Simplified Illustration

Step 1 – Calculating EADi  and M i  

Assuming that Bank Y determines the exposure atdefault for OTC derivatives by reference to the CCRmark-to-market method, EADi is calculated as follows:

EADi  Amount (in EUR)EADCorporate

X EUR 10mm x 1%7 = EUR 100,000

EADParent  EUR 10mm x 1% = EUR 100,000

The (discounted) exposure at default is then calculatedby applying a standardised discounting factor based onthe maturity of the transaction.

The effective maturity of both foreign exchangetransactions is six months when Bank Y enters intothem on 1 November 201X.

Step 2 – Calculating w i  

As noted above, the weight is based on thecounterparty’s external credit rating. Because Company

 ‘X’ has a credit rating of  ‘A-’ , its weight is 0.8%

6  For illustration’s purposes, we assume that these

are the only two transactions entered into by Bank ‘Y’. 

7  It is noted that 1% is the standard percentageapplied to the notional of a forward foreign currencycontract with a maturity of 12 months or less to

determine its potential future exposure under themark-to-market method.

whereas the Parent has a rating of ‘AA-’ , i.e. a weightof 0.7%.Step 3 – Calculating the Capital Requirement for CVARisk and Credit Counterparty Risk (CCR)

On 1 November 201X, the capital requirement for CCR

(as exists under the current Basel 2 and CRDrequirements) is EUR 5,600, i.e.:8   Company X = EUR 100,000 * 50% * 8%

= EUR 4,000; and

  Parent = EUR 100,000 * 20% * 8%

= 1,600.

The additional capital requirement arising from CVA on01 November 201X risk is calculated by reference tothe above formula and amounts to EUR 1,366.

The CCR and CVA capital requirement will evolve overtime as the exposure at default9 and effective maturityvary.

Drivers of the Capital Requirement forCVA Risk

In the simplistic example above, CVA risk requires anadditional 25% capital requirement as compared to thecounterparty credit risk capital requirement under Basel2/CRD. In the paragraphs that follow, we will examinesome of the key drivers of the capital requirement forCVA risk. The understanding of these key drivers canhelp credit institutions to evaluate the materiality of theimpact of the CVA risk capital requirement based ontheir existing portfolios of OTC derivatives and productoffering. It can also help them in evaluating the needto:

(i)  review their portfolios and product offering,(ii)  adopt hedging strategies, and/or

(iii)  use CCPs for clearing purposes.

Counterparty Credit Rat ing

The counterparty credit rating determines the (risk)weight for the CVA calculation. For the highest creditrating grade (i.e., AAA to AA-) the CVA (risk) weight is0.7%; it increases to 10% for counterparties with acredit rating of CCC and below.

To illustrate the impact of counterparty credit rating onthe capital requirement for CVA risk, we assume thatBank Y has a trading portfolio consisting of eight

foreign exchange forward transactions with eightdistinct counterparties. Each transaction has an effective maturity of three months. The resulting totalexposure (i.e., EAD) is EUR 81mm. 

8  The calculation assumes that Bank Y uses the

Standardised credit risk approach under Basel2/CRD whereby the respective risk weights basedon the applicable external credit ratings are 50%and 20%, respectively . It also assumes that Bank Yis subject to an 8% capital adequacy ratiorequirement.

9  Exposure at default will vary over time as a result ofchanges in the mark-to-market value of the

transactions and the related potential futureexposures.

Parent

Rating = AA-

COMPANY ‘X’ 

Rating = A-

BANK

‘Y’ 

€10 mio 

€10 mio 

$14 mio

Forward exchange contracts

Maturity = 6 months

Bank’s Functional CCY: EUR

$14 mio 

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The figure below examines how the capital requirementfor CVA risk (blue bars) evolves based on the external

credit rating of the counterparties, ceteris paribus.10 The red line represents the increase in the capitalrequirement resulting from the CVA risk by comparison

to the existing CCR capital requirement under Basel2/CRD (expressed as a percentage).

0%

5%

10%

15%

20%

25%

30%

35%

 -

 500

 1.000

 1.500

 2.000

 2.500

 3.000

 3.500

AAA AA A BBB BB B CCC

   C   V   A    /   C   C   R

   C   V   A ,   E   U   R

   x   1   0   0   0

Credit rating grade

CVA

CVA/CCR

 Figure 2: CVA as a function of External Ratings

It is clear that the capital requirement for CVA riskparticularly penalises credit institutions that work withless credit worthy counterparties and that on amarginal basis there is a disproportionally larger CVAincrease over the corresponding CCR capitalrequirement for poorly rated counterparties. It shouldbe noted that unrated counterparties are treated asBBB rated counterparties.

Effect ive Maturi ty of the Transact ions

The effective maturity of the transactions with a

counterparty impacts the capital requirement at twolevels:  First, it directly impacts the calculation as it is

a factor (Mi) included in the regulatoryformula; and

  It generally has a direct and indirect impact onthe exposure at default (EAD i) since theeffective maturity is a significant driver in thecalculation of the potential future exposureand impacts the discounting factor used incalculating the discounted EAD.

To illustrate the impact of the effective maturity on thecapital requirement for CVA risk, we assume that BankY has a trading portfolio consisting of one foreign

exchange forward transaction with one counterparty(notional = EUR 20mm).

The figures below examine how the capital requirementfor CVA risk (blue bars) evolves as the effectivematurity varies between 1 and 12 months (figure 3), 13and 60 months (figure 4), and 60 to 72 months (figure4), ceteris paribus. The red line represents the increasein the capital requirement resulting from the CVA riskby comparison to the existing CCR capital requirementunder Basel 2/CRD (expressed as a percentage).

10  Under this simplified example, all eight

counterparties are assumed to have the sameexternal credit rating.

0%

5%

10%

15%

20%

25%

30%

0

0,5

1

1,5

2

2,5

3

3,5

4

4,5

5

1 2 3 4 5 6 7 8 9 10 11 12

   C   V   A    /   C   C   R

   C   V   A ,   E   U   R

   x   1   0   0   0

Maturity, months

CVA (maturiy ≤ 1 year)

 

Figure 3: CVA as a function of Maturity (1 to 12 months)

0%

20%

40%

60%

80%

100%

120%

140%

0

20

40

60

80

100

120

13 16 19 22 25 28 31 34 37 40 43 46 49 52 55 58

   C   V   A    /   C   C   R

   C   V   A

 ,   E   U   R

   x   1   0   0   0

Maturity, months

CVA (1 year < maturity ≤ 5 years )

 

Figure 4: CVA as a function of Maturity (13 to 60 months)

120%

125%

130%

135%

140%

145%

150%

155%

140

145

150

155

160

165170

175

180

185

61 62 63 64 65 66 67 68 69 70 71 72

   C   V   A    /   C   C   R

   C   V   A ,   E

   U   R

   x   1   0   0   0

Maturity, months

CVA - (maturity > 5 years )

 

Figure 5: CVA as a function of Maturity (60 to 72 months)11

 

It is clear that the capital requirement for CVA riskparticularly penalises credit institutions that offer long-dated OTC derivatives to their clients.

Port fo l io Concentrat ionA further driver is sometimes overlooked by creditinstitutions, i.e. the relationship between the degree ofconcentration within their portfolio and the relativeimpact of CVA risk.

To illustrate this relationship, we assume that Bank Yhas a trading portfolio resulting in a total exposure ofEUR 81mm. We assume that all counterparties have anexternal rating of BBB (i.e. wi = 1%) and the effective maturity of the transactions is three months (Mi  =0.25). 

11

  It is noted that beyond 72 months, the capitalrequirement for CVA grows linearly.

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The figure below examines how the capital requirementfor CVA risk (blue bars) evolves as the number of

counterparties included in the portfolio increases(assuming that the total portfolio exposure, i.e. EUR81mm, is equally distributed amongst the

counterparties). The red line represents the increase inthe capital requirement resulting from the CVA risk bycomparison to the existing CCR capital requirementunder Basel 2/CRD (expressed as a percentage).

0%

1%

2%

3%

4%

5%

6%

7%

8%

0

50

100

150

200

250

300

350

400

450

500

1 5 9 13 17 21 25 29 33 37 41 45 49

   C   V   A    /   C   C   R

   C   V   A ,   E   U   R

   x   1   0   0   0

Number of counterparties

CVA

CVA/CCR

 

Figure 6: CVA as a function of Concentration

Conclusions

The introduction of the CVA capital requirement underBasel 3 and CRD 4 will significantly increase the totalcapital requirement for credit institutions offering OTCderivatives.

While this Practice Note uses simplistic examples, the

overall conclusions remain valid where institutions usemore sophisticated models to calculate counterpartycredit risk exposures and CVA risk. 

November 2011 

Contact

Frederic GielenPartnerAvantage Reply 

5th Floor | Dukes House | 32-38 Dukes Place | London EC3A

7LPTel: +44 20 7709 4000

E-mail: f.gielen@reply.eu 

Ilya KraevSenior ConsultantAvantage Reply 

149/24 Avenue Loiuse | Brussels 1050Tel: +32 2 535 7442E-mail: i.kraev@reply.eu