According to Wikipedia, CVA is defined as the difference between the risk-free portfolio value and the true portfolio value that takes into account the possibility of a counterparty’s default.
What does the 'risk-free portfolio value' mean? I guess it's similar to the risk premium (risky asset return - riskfree asset return), but can anyone provide an example of the risk-free portfolio value in the context of CVA?
Thank you.
If you have a portfolio of derivatives with a counterparty and this counterparty defaults before the trades mature, the net mark to market value of the portfolio will be calculated according to the master agreement and a close-out amount will be supposed to be paid by one party to the other.
If this portfolio has a positive mark to market value (from your point of view), you won't be able to recover the full amount in the insolvency proceedings, but rather only a part of it (determined by the recovery rate).
This means there's a probability that you incur a loss, due to counterparty credit risk. CVA is basically the (risk-neutral) expected value of this loss, or equivalently the price of hedging this risk in the market.
Wikipedia is wrong.
CVA/DVA is the cost of the marginal credit (counterparty) risk created when a (partially) unsecured derivative is traded.
It is not a derivative and not hedgeable at inception.
The mainstream approach is to approximate it by a contingent CDS (CCDS), which actually IS a derivative.
