What is it?
CVA? The positive or negative market value of counterparty credit risk related to a set of future net cash inflows or outflows.
Assume that the position of interest is a swap agreement with a specific counter party. For the valuation, you calculate the expected present values of future cashflows, where some realizations of these cashflows will be positive for you, some will be negative. If the counter party defaults, the positive outcomes (for you) will become less valuable. This adjustment taking into account the credit risk of the counter party is carried out in CVA.
FVA? Similar to the CVA concept but reflecting the positive or negative market value of cost or benefit to fund a derivative
DVA? Adjustment to reflect the market value of non-performance risk to the carrying value of fixed income securities issued by a company
How to deal with it?
The continuing financial crisis has led to significant changes in the valuation of derivatives contracts. Fair value continues to be one of the key issues for the banking sector. Risk-free world or real world? This discussion is influenced by methodology and technology.
New accounting standards force the adjustment of credit or fund values (CVA/FVA) or even more controversial debt values (DVA) - DVA allows an institution to report profit as its health deteriorates ....?
However, the adjustments need to rely on exposure modeling, the prediction of future cash flows of a portfolio with a counter party.
This introduces much more complexity in the valuation space, relevant to trading, risk management and accounting.
UnRisk is a valuation and risk management technology and we have already shown that, for example, the calculation of Monte Carlo VaRs with full valuation for a moderately complex portfolio needs enormous computing muscles and optimized numerical schemes for the over night valuation.
And this is what we do first - make valuation engines as blazingly fast as required and organize them intelligently in high level tasks
With VAs one may run into requirements of billions of single valuations for portfolios with a major counter party and general derivatives.
Selecting momentary technologies blindly may make it impossible to achieve the ambitious goals (full valuation with LMM?). Data and valuation management needs to be integrated carefully and an exposure modeling engine needs to work event driven.
With this respect we are in the middle of the VA project. Manage the valuation side first - and do it the UnRisk way: build a sound fundament for a really tall bullding
Picture from sehfelder