Implications of CVA for Financial Stability in Over-the-Counter Derivatives Markets: A Simulation Analysis

Abstract

In this paper, we propose a simulation framework to assess the risk of financial contagion in over-the-counter (OTC) derivatives markets. We incorporate Credit Valuation Adjustment (CVA), a mark-to-market estimate of counterparty credit risk booked in a bank's balance sheet, into a model of interbank network. In this simulation framework, a bank can make a margin call and purchase protection in credit default swap (CDS) markets in order to reduce CVA. We also model the adverse market impacts in CDS markets where the bank's CVA hedging increases CDS spreads due to the lack of liquidity. A financial shock propagates through the interbank linkage of CVA and banks' CDS markets. Utilizing this simulation framework, we study the impact of four different shocks on the financial soundness of banks in the OTC derivatives markets: a large loss from a credit portfolio, a large loss from a derivative trade, a market-wide haircut rate change and a downgrade trigger. We also analyze whether and to what extent the introduction of central clearing party (CCP) attenuates the negative effect of CVA hedging on the financial stability. Our simulation results highlights the importance of understanding collateral management at bank level to assess a potential contagious risk in the OTC derivatives markets.