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Credit Value Adjustment

(CVA): The Standardised
Method

Frederic Gielen,
Partner
Avantage Reply

Ilya Kraev,
Senior Consultant
Avantage Reply

Introduction
The CVA of an OTC derivatives portfolio with a given
counterparty is the market value of the credit risk due
to any failure to perform on agreements with that
counterparty4.
Basel 3 and the proposed CRD 4 require credit
institutions to calculate capital requirements for CVA for
all OTC derivative instruments in respect of all of
business activities, other than credit derivatives
intended to mitigate the risk-weighted exposure
amounts for credit risk.
Transactions with central counterparties (CCPs) are
excluded from the capital requirements for CVA risk.
Securities Financing Transactions (SFTs)for example
reposare excluded in the calculation of capital
requirements for CVA risk, unless the regulator
determines that the institution's CVA risk exposures
arising from those transactions are material.

The Standardised Method

Regulatory Formula

apid and continuous growth of the

OTC derivatives market with a
volume of over USD600 trillion as of
year end 20101 and the significance
of losses due to counterparty
default in such contracts caused
regulators to introduce new regulation requiring
additional capital with respect to counterparty
risk.
In a discussion paper dated April 2010,2 the FSA
analysed the losses related to different types of
assets
and
concluded
that
two-thirds
of
counterparty credit risk losses were attributable
to Credit Valuation Adjustment (CVA) and only
about one-third were due to actual counterparty
defaults.
The CVA capital requirements introduced by Basel
3 (and its European version, the proposed CRD 4)
seek to ensure that credit institutions hold capital
to mitigate the credit risk losses attributable to
CVA.
There are two methodologies for calculating the
capital requirements for CVA, the Advanced
Method and the Standardised Method.

Institutions using the Standardised Method must

calculate the capital requirements for CVA risk in
accordance with the following:4
where:

h is a one-year time horizon, i.e. h=1;

Banks for International Settlements, OTC

derivatives markets activity in the second half of
2010, May 2011.
Financial Services Authority, The prudential regime
for trading activities A fundamental review,
August 2010.
The Advanced Method requires the institution to
have Internal Model Method (IMM) approval for

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wi is the (risk) weight of the counterparty. It

ranges from 0.7% to 10% depending on the
credit quality of the counterparty;

EADi and Mi represent the (discounted)

exposure at default of Counterparty i
(including the effect of credit risk mitigation)
and the effective maturity of the transactions
with Counterparty i.5

In this Practice Note we will assume that CVA is not

hedged and hence will not make reference to other
elements included in the standard formula above.
There are several steps to be performed to calculate
the capital requirements for CVA risk:

The first is to calculate the (discounted)

exposure at default and effective maturity of
the transactions across the netting sets with
the counterparty;

In this practice note, we explain what CVA is, how

it is measured under the Standardised Method
and the key drivers that impact the amount of
regulatory capital required for CVA.3

The second step is to assign the appropriate

weight to the counterparty. The weight is

Counterparty Credit Risk (CCR) and internal model

approval for the specific risk of debt instruments. In
December, Avantage Reply will issue a Practice Note
reviewing some specific issues relating to CVA under
the Advanced Method.
For a detailed review of the formula, please refer to
Basel 3 (Paragraph 104) and CRD 4 (Article 374).
It is noted that there is a difference between the
version of Basel 3 published in June 2011 and CRD
4. Whereas CRD 4 currently maintains a five-year
cap for the Maturity, this cap has been removed in
the June revision of Basel 3.

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based on the counterpartys external credit

rating; and

The final step is to calculate the capital

requirement for CVA risk.
6

Illustration

On 1 November 201X, Company X (a large corporate)

enters into a 6-month foreign exchange contract
(selling USD 14 million and buying EUR 10 million) with
Bank Y, to hedge its foreign currency risk.
Bank Y enters into a back-to-back transaction with its
Parent on the same day, i.e. Bank Y sells USD 14
million and buys EUR 10 million forward.

Parent
Rating = AA-

Forward exchange contracts

Maturity = 6 months
Banks Functional CCY: EUR

10 mio
$14 mio

BANK
Y
10 mio

Figure 1: Simplified Illustration

Step 1 Calculating EADi and Mi
Assuming that Bank Y determines the exposure at
default for OTC derivatives by reference to the CCR
mark-to-market method, EADi is calculated as follows:
EADi
EADCorporate
X

EADParent

Amount (in EUR)

EUR 10mm x 1%7 = EUR 100,000
EUR 10mm x 1% = EUR 100,000

The (discounted) exposure at default is then calculated

by applying a standardised discounting factor based on
the maturity of the transaction.
The effective maturity of both foreign exchange
transactions is six months when Bank Y enters into
them on 1 November 201X.
Step 2 Calculating wi
As noted above, the weight is based on the
counterpartys external credit rating. Because Company
X has a credit rating of A-, its weight is 0.8%
6

On 1 November 201X, the capital requirement for CCR

(as exists under the current Basel 2 and CRD
requirements) is EUR 5,600, i.e.:8

Company X = EUR 100,000 * 50% * 8%

= EUR 4,000; and

Parent

= EUR 100,000 * 20% * 8%

= 1,600.

The additional capital requirement arising from CVA on

01 November 201X risk is calculated by reference to
the above formula and amounts to EUR 1,366.
The CCR and CVA capital requirement will evolve over
time as the exposure at default9 and effective maturity
vary.

Drivers of the Capital Requirement for

CVA Risk

$14 mio

COMPANY X
Rating = A-

whereas the Parent has a rating of AA-, i.e. a weight

of 0.7%.
Step 3 Calculating the Capital Requirement for CVA
Risk and Credit Counterparty Risk (CCR)

For illustrations purposes, we assume that these

are the only two transactions entered into by Bank
Y.
It is noted that 1% is the standard percentage
applied to the notional of a forward foreign currency
contract with a maturity of 12 months or less to
determine its potential future exposure under the
mark-to-market method.

In the simplistic example above, CVA risk requires an

additional 25% capital requirement as compared to the
counterparty credit risk capital requirement under Basel
2/CRD. In the paragraphs that follow, we will examine
some of the key drivers of the capital requirement for
CVA risk. The understanding of these key drivers can
help credit institutions to evaluate the materiality of the
impact of the CVA risk capital requirement based on
their existing portfolios of OTC derivatives and product
offering. It can also help them in evaluating the need
to:
(i)
review their portfolios and product offering,
(ii)
adopt hedging strategies, and/or
(iii)
use CCPs for clearing purposes.

Counterparty Credit Rating

The counterparty credit rating determines the (risk)
weight for the CVA calculation. For the highest credit
rating grade (i.e., AAA to AA-) the CVA (risk) weight is
0.7%; it increases to 10% for counterparties with a
credit rating of CCC and below.
To illustrate the impact of counterparty credit rating on
the capital requirement for CVA risk, we assume that
Bank Y has a trading portfolio consisting of eight
foreign exchange forward transactions with eight
distinct counterparties. Each transaction has an
effective maturity of three months. The resulting total
exposure (i.e., EAD) is EUR 81mm.

The calculation assumes that Bank Y uses the

Standardised credit risk approach under Basel
2/CRD whereby the respective risk weights based
on the applicable external credit ratings are 50%
and 20%, respectively. It also assumes that Bank Y
is subject to an 8% capital adequacy ratio
requirement.
Exposure at default will vary over time as a result of
changes in the mark-to-market value of the
transactions and the related potential future
exposures.

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CVA, EUR x 1000

35%
CVA

3.000

30%

CVA/CCR

2.500

25%

2.000

20%

1.500

15%

1.000

10%

CVA/CCR

CVA, EUR x 1000

3.500

5
4,5
4
3,5
3
2,5
2
1,5
1
0,5
0

30%
25%
20%

CVA/CCR

CVA (maturiy 1 year)

The figure below examines how the capital requirement

for CVA risk (blue bars) evolves based on the external
credit rating of the counterparties, ceteris paribus.10
The red line represents the increase in the capital
requirement resulting from the CVA risk by comparison
to the existing CCR capital requirement under Basel
2/CRD (expressed as a percentage).

15%
10%
5%
0%
1

10

11

12

Maturity, months

Figure 3: CVA as a function of Maturity (1 to 12 months)

0%
AAA

AA

BBB

BB

CCC

Credit rating grade

Figure 2: CVA as a function of External Ratings

The figures below examine how the capital requirement

for CVA risk (blue bars) evolves as the effective
maturity varies between 1 and 12 months (figure 3), 13
and 60 months (figure 4), and 60 to 72 months (figure
4), ceteris paribus. The red line represents the increase
in the capital requirement resulting from the CVA risk
by comparison to the existing CCR capital requirement
under Basel 2/CRD (expressed as a percentage).

10

Under this simplified example, all eight

counterparties are assumed to have the same
external credit rating.

100%

80

80%

60

60%

40%
20%

0%
13 16 19 22 25 28 31 34 37 40 43 46 49 52 55 58

Maturity, months

Figure 4: CVA as a function of Maturity (13 to 60 months)

CVA - (maturity > 5 years )
CVA, EUR x 1000

The effective maturity of the transactions with a

counterparty impacts the capital requirement at two
levels:

First, it directly impacts the calculation as it is

a factor (Mi) included in the regulatory
formula; and

To illustrate the impact of the effective maturity on the

capital requirement for CVA risk, we assume that Bank
Y has a trading portfolio consisting of one foreign
exchange forward transaction with one counterparty
(notional = EUR 20mm).

120%

20

Effective Maturity of the Transactions

It generally has a direct and indirect impact on

the exposure at default (EADi) since the
effective maturity is a significant driver in the
calculation of the potential future exposure
and impacts the discounting factor used in
calculating the discounted EAD.

100

40

It is clear that the capital requirement for CVA risk

particularly penalises credit institutions that work with
less credit worthy counterparties and that on a
marginal basis there is a disproportionally larger CVA
increase
over
the
corresponding
CCR
capital
requirement for poorly rated counterparties. It should
be noted that unrated counterparties are treated as
BBB rated counterparties.

140%

CVA/CCR

120

185
180
175
170
165
160
155
150
145
140

155%
150%
145%

CVA/CCR

5%

CVA, EUR x 1000

CVA (1 year < maturity 5 years )

500

140%
135%

130%
125%
120%
61

62

63

64

65

66

67

68

69

70

71

72

Maturity, months

Figure 5: CVA as a function of Maturity (60 to 72 months)

11

It is clear that the capital requirement for CVA risk

particularly penalises credit institutions that offer longdated OTC derivatives to their clients.

Portfolio Concentration
A further driver is sometimes overlooked by credit
institutions, i.e. the relationship between the degree of
concentration within their portfolio and the relative
impact of CVA risk.
To illustrate this relationship, we assume that Bank Y
has a trading portfolio resulting in a total exposure of
EUR 81mm. We assume that all counterparties have an
external rating of BBB (i.e. wi = 1%) and the effective
maturity of the transactions is three months (Mi =
0.25).

11

It is noted that beyond 72 months, the capital

requirement for CVA grows linearly.

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500

8%

CVA

450

CVA/CCR

400

7%
6%

350
300

5%

250

4%

200

3%

150

CVA/CCR

CVA, EUR x 1000

The figure below examines how the capital requirement

for CVA risk (blue bars) evolves as the number of
counterparties included in the portfolio increases
(assuming that the total portfolio exposure, i.e. EUR
81mm,
is
equally
distributed
amongst
the
counterparties). The red line represents the increase in
the capital requirement resulting from the CVA risk by
comparison to the existing CCR capital requirement
under Basel 2/CRD (expressed as a percentage).

2%

100

1%

50
0

0%
1

13

17

21

25

29

33

37

41

45

49

Number of counterparties

Figure 6: CVA as a function of Concentration

Conclusions
The introduction of the CVA capital requirement under
Basel 3 and CRD 4 will significantly increase the total
capital requirement for credit institutions offering OTC
derivatives.
While this Practice Note uses simplistic examples, the
overall conclusions remain valid where institutions use
more sophisticated models to calculate counterparty
credit risk exposures and CVA risk.

November 2011
Contact
Frederic Gielen
Partner
Avantage Reply
5th Floor | Dukes House | 32-38 Dukes Place | London EC3A
7LP
Tel: +44 20 7709 4000
E-mail: f.gielen@reply.eu
Ilya Kraev
Senior Consultant
Avantage Reply
149/24 Avenue Loiuse | Brussels 1050
Tel: +32 2 535 7442
E-mail: i.kraev@reply.eu

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