In the previous post, we described the Exposure and Potential Future Exposure (PFE) measures in CVA. This post describes the general netting concept in our CVA demo, and the CVA of a specific netting node.
About the Netting Concept
When obtaining data relating to counterparty credit risk management, we net exposure at netting nodes, which correspond to an aggregate set of trades all related to one single counterparty (at legal entity level, not at group level). For example we can create asset class nodes (Equity, FX…) under a specific legal entity (Cathay Pacific Airways Ltd, itself a node of the Cathay Pacific group).
Below is an illustration of the impact of netting on exposure. Possible MtM scenarios are shown on the left-hand side with the exposures on the right.
Netting Concept and CVA
In counterparty credit risk management, when performing a trade with a given counterparty, there is no guarantee that this counterparty will never default during the lifetime of the trade. The CVA is trying to price this risk.
The CVA of a netting node is defined as follows:
- If E t is the exposure of this node at time t
- if D t-1,t is the probability that this node’s counterparty defaults between the time points (t-1) and t
- if PV t is the discount factor at time t (that yields the present value)
- if r is the recovery rate, i.e. the percentage of our assets that we will be able to recover from the counterparty if its defaults, then the CVA of this node is:
Therefore the aggregated CVA of a set of trades is once again a dynamic computation. In the counterparty credit risk management process, we compute the CVA of each netting node (and treat non-netted trades as the single element of a netting node), then long sum the resulting CVA altogether (taking only the positive values) to obtain the final result.
In our demo, the default probability D, is computed based upon the rating of the counterparty. If you were to decide to change the latter using the ‘what if’ button on ActivePivotLive then you can see the CVA values change instantly. The ‘what if’ button brings up a pop-up with all counterparties for which you can then select to change the rating from A for instance to BB reflecting a downgrading for instance.
In the next post we will explain about the marginal exposure and delta CVA concepts, and list related benchmarks.