6 - Counterparty Credit Risk and Credit Valuation Adjustments (CVAs) for Interest Rate Derivatives–Current Challenges for CVA Desks

Abstract

Before the recent financial crisis, banks charging risk premiums to cover the possibility of counterparty default for over-the-counter interest rate derivatives constituted a small portion of the market. However, the financial crisis proved that counterparty credit risk (CCR) arising from derivatives should be given adequate attention. Markets are now evolving accordingly. Accounting standards require the adjustment of derivative values for the possibility of counterparty default. Regulators are tightening CCR-related rules. This chapter sets out traditional and new risk management approaches to handle CCR. After setting out the basics of credit exposure modeling and credit value adjustment calculation, special attention is given to new challenges and practical problems currently faced by banks striving to comply with accounting, regulatory and bank internal requirements. The new market environment has a strong impact on the business model of banks and requires them to adapt to the new framework.