Sapient Global Markets risk analytics director Jor Molchan and senior associate Richard Ellis discuss the advantages – and challenges – of implementing an efficient credit valuation adjustment programme

The market volatility and numerous counterparty defaults experienced since September 2008 have shown the limitations of traditional credit risk monitoring techniques.

Credit lines welcome exposure until the cap is reached; thereafter exposure is simply refused. In an industry where risk is routinely 'dollarised', exposure caps fall far short of the mark.

Collateral management has proven itself to be too reactive to market movements and plagued with operational and legal failures. Both techniques also suffer from being backward-looking and reactive in their application.

Mixing credit limits, collateral management and third-party guarantees - as some institutions do - creates a complex and inconsistent mix that risks blurring the true picture of counterparty exposure. It also fails to incentivise trading decisions in the best interest of the organisation.

These statements are, however, not revolutionary; firms have recognised this and alternatives have been sought and found. Credit value adjustment (CVA) is the industry standard here.

The benefits of CVA are clear; CVA creates dynamic risk exposure monitoring that puts a dollar value on the cost of the risk incurred, or more accurately, the cost to hedge the risk. The risk offsetting hedge does not have to be purchased: an institution is free to carry the risk. What CVA does is allow for a decision to be made as to how much of that risk should be taken on - with eyes wide open.

Laser focused
We can say that decisions made using CVA are made with eyes wide open because CVA permits trade-by-trade risk management, making it as tightly focused as possible. CVA does this all in the context of the bigger picture by including aggregate exposure and marginal impacts to that exposure on a trade-by-trade basis.

CVA provides a true credit exposure position and real-time trading impacts. The nature of CVA allows for - in fact, highlights - the risk and enables an informed decision on what level, or dollar amount, of risk should be maintained and which risks should be hedged.

By highlighting the trade-by-trade impact and cost, CVA incentivises good decisions. The terms available for riskier trades make them harder to execute profitably. When they are executed an opportunity is created for trades that offset risk to be priced even more competitively.

Risk-taking behaviour thus subsidises risk-reducing behaviour. CVA consequently acts as a tool for monitoring, measuring and managing risk-taking decisions in the best interest of the company.

The cost
As the benefits of effectively using CVA are so great, they of course come at no small cost. Implementing and using CVA represents a significant cost for firms.

CVA is wrought with challenges, including:

• Data-heavy calculations
• Long processing times
• Costly implementation.

These costs can be paid continuously over the life of the CVA system in slow processing and heavy maintenance burdens or upfront in the development and implementation challenges faced when creating an industry-leading programme that manages key issues for both the current environment and the long-term direction of the firm. An effective CVA system will do this by appropriately managing the data burden with resources that match the volumes, while relying on real-time information - not end-of-day data - and by using calculation methods and engines that will result in the fastest calculations.

Real-time CVA is more than just a gold standard; it is the only way to capture its full benefits. A robust risk management capability, including the ability to determine which risks to hedge and which to carry, doesn't work if its function is a day behind the trades.

Neither will a CVA programme that covers most of the asset classes or instrument types. This CVA programme leaves gaping holes in the risk management programme.

CVA must cover all traded asset classes and instrument types across all desks, departments and divisions. Without this, the aggregate picture is inaccurate at the level of the individual counterparty and when aggregated across business lines.

CVA has several exceptional issues that add a level of complexity for any risk manager; however, for all involved, it is still an investment worth making.

Wrong-way risk: Wrong-way risk is incurred when the counterparty's financial strength weakens under the same market conditions that turn their positions against them. Taking the long side of an airline's short oil position would qualify as wrong-way risk because an increase in the cost of oil would hurt both their position and financial strength. Ideal CVA programmes will address right-way and wrong-way risk considerations.

Close-out netting: If close-out netting provisions are not considered, a CVA programme will default to the assumption that close-out netting is applicable to the full portfolio of any counterparty. This is a by-product of an analysis that considers the marginal, not the gross risk of each additional position. Of course, if there is an alternate structure - something other than full close-out netting across all of a counterparty's deals - the CVA programme needs to recognise this.

As CVA expands its application throughout the industry, questions will turn to how robust and how soon, rather than if and when. The value of CVA is clear: CVA can be used to improve risk management and measurement; it can incentivise good trading decisions by discouraging trades that negatively affect the risk profile; and it ensures accurate matching to counterparty marks.

The challenges of using CVA effectively are also quite clear cut. However, most important of these are the deficiencies that lead to a CVA analysis which is incomplete in its reach or too slow in its functioning. A near ideal CVA implementation is anything but.