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- Ch16HullOFOD9thEdition
- Options, Futures, and Other Derivatives, 10th Edition, Copyright © John C. Hull 2017
- Options, Futures, and Other Derivatives, 10th Edition, Copyright © John C. Hull 2017
- Options, Futures, and Other Derivatives, 10th Edition, Copyright © John C. Hull 2017
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- Options, Futures, and Other Derivatives, 10th Edition, Copyright © John C. Hull 2017
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- Options, Futures, and Other Derivatives, 10th Edition, Copyright © John C. Hull 2017
- Options, Futures, and Other Derivatives, 10th Edition, Copyright © John C. Hull 2017
- Options, Futures, and Other Derivatives, 10th Edition, Copyright © John C. Hull 2017
- Options, Futures, and Other Derivatives, 10th Edition, Copyright © John C. Hull 2017
- Options, Futures, and Other Derivatives, 10th Edition, Copyright © John C. Hull 2017
- Options, Futures, and Other Derivatives, 10th Edition, Copyright © John C. Hull 2017
- Options, Futures, and Other Derivatives, 10th Edition, Copyright © John C. Hull 2017
- Options, Futures, and Other Derivatives, 10th Edition, Copyright © John C. Hull 2017
- Options, Futures, and Other Derivatives, 10th Edition, Copyright © John C. Hull 2017
- Options, Futures, and Other Derivatives, 10th Edition, Copyright © John C. Hull 2017
- Options, Futures, and Other Derivatives, 10th Edition, Copyright © John C. Hull 2017
- Options, Futures, and Other Derivatives, 10th Edition, Copyright © John C. Hull 2017
- Options, Futures, and Other Derivatives, 10th Edition, Copyright © John C. Hull 2017

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XVAs

Copyright John C. Hull 2017 1

CVA

Credit valuation adjustment (CVA) is an

adjustment to the no-default value of

derivatives arising from the possibility of a

counterparty default

Copyright John C. Hull 2017 2

Netting

Master agreements for bilaterally cleared

transactions typically state that outstanding

transactions are netted in the event of a default. For

example, if there are two outstanding transactions

worth +10 and -6 with a counterparty the potential

loss in the event of default (assuming no collateral) is

4. not 10.

This means that CVA must be calculated on a

counterparty-by-counterparty basis, not on a

transaction-by-transaction basis.

Options, Futures, and Other Derivatives 10th Edition,

Copyright John C. Hull 2017 3

DVA

Debit (or debt) valuation adjustment is an

adjustment to a banks no-default value

because the bank itself might default.

The banks DVA is the counterpartys CVA

Like CVA, DVA must be calculated on a

counterparty-by-counterparty basis

vi*

Copyright John C. Hull 2017 4

Valuing Bilaterally Cleared

Derivatives Portfolios continued

Value after credit adjustments is:

No-default value CVA + DVA

CVA and DVA adjustments should reflect

collateral arrangements

Why does DVA increase the value of the

portfolio of transactions with the

counterparty?

Copyright John C. Hull 2017 5

The CVA Calculation

Time 0 t1 t2 t3 t4 tn=T

Counterparty q1 q2 q3 q4 qn

default

probability

PV of dealers loss v1 v2 v3 v4 vn

given default

n

CVA qi vi

i 1

Copyright John C. Hull 2017 6

The DVA Calculation

Time 0 t1 t2 t3 t4 tn=T

probability

PV of v 1* v 2* v 3* v 4* v n*

counterpartys loss

given default

n

DVA qi vi

i 1

Copyright John C. Hull 2017 7

FVA and MVA (Figure 9.1)

Consider the situation where a bank enters into

a transaction with an end user where no margin

is posted and hedges this by entering into an

offsetting transaction with another bank:

2.9% 3.0%

Corporate

Bank A Bank B

End User

LIBOR LIBOR

Copyright John C. Hull 2017 8

FVA and MVA continued

FVA is the expected cost of the incremental

variation margin on the hedge transaction

MVA is the expected cost of the incremental

initial margin on the hedge transaction

Copyright John C. Hull 2017 9

The Cost

Many banks use their average debt funding cost to

calculate the cost of FVA and MVA

Financial economic theory would suggest that the

initial margin and variation margin are low risk

investments. The required return is less than the

banks average funding cost

If the return required on margin is the fed funds rate

plus 10 bps and the interest earned on margin is the

fed funds rate minus 20 basis points, the funding cost

(possibly a benefit in the case of FVA) is 30bps

Options, Futures, and Other Derivatives 10th Edition,

Copyright John C. Hull 2017 10

KVA

KVA is the capital valuation adjustment.

This is an adjustment for the incremental capital

requirements associated with a derivative

Many banks consider the cost of incremental capital

to be the required return on equity

Financial economists would argue that additional

equity makes the bank less risky and should reduce

the required return on both debt and equity

Copyright John C. Hull 2017 11

Calculation Issues

The calculation of all the XVAs involve very

time-consuming Monte Carlo simulations.

This is because it is necessary to calculate

expected future exposures for both bank and

counterparty (in the case of CVA and DVA)

expected future variation and initial margin

requirements (in the case of FVA and MVA)

expected future capital requirements (in the case

of KVA)

Options, Futures, and Other Derivatives 10th Edition,

Copyright John C. Hull 2017 12

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