University of Twente Student Theses


The CVA trade-off: Capital or P&L.

Boer, T.M. de (2017) The CVA trade-off: Capital or P&L.

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Abstract:Credit valuation adjustment (CVA) has become an important aspect of accounting and regulatory standards. On the one hand, the regulatory standards (Basel accords) demand a capital risk charge for CVA volatility. Basel allows to hedge the CVA, which results in a reduction of the risk charge. On the other hand, the accounting standards (IFRS) require that the financial instrument is valued at fair value, which is achieved by including CVA. Consequently, changes in CVA have an effect on P&L, since fluctuations of the instrument’s value affect the balance sheet equity. However, there is a mismatch between hedging the regulatory risk charge and accounting P&L volatility. The hedge instruments reducing the risk charge cause additional P&L volatility, due to the fact that the regulatory view on CVA is more conservative than the accounting one (Berns, 2015; Pykhtin, 2012}. There is a trade-off between achieving risk charge reduction and creating additional P&L volatility. We present a methodology to define the optimal hedge amounts, which leads to maximal CVA charge reduction while minimizing additional P&L volatility. The Hull-White model is selected to simulate the risk factors determining the value of the interest rate swap of time. By applying the Monte Carlo method, the expected exposure path is found. Furthermore, the CDS spreads are simulated, which are used in the CVA calculation and CDS calculation. The combination of results are implemented in the regulatory and accounting regimes, yielding in the CVA risk charge and CVA P&L. Using the optimization criteria, we found the optimal hedge amount for each risk appetite. In the implementation case we use an interest rate swap, due to the notional size of interest rate derivatives to the OTC market. Here, we present a step-by-step guidance from implementing the risk factor model to finding the optimal hedging amount. For a bank more focused on capital, we see that the hedge amount should be set closer to Basel's EAD level. For a bank focused on reducing additional P&L volatility, we find that the hedge amount should be set closer to expected exposure level.
Item Type:Essay (Master)
Faculty:BMS: Behavioural, Management and Social Sciences
Subject:31 mathematics, 85 business administration, organizational science
Programme:Industrial Engineering and Management MSc (60029)
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