How Credit Valuation Adjustment Affects a Derivative’s Quoted Price

Summary

The document raises an intuition question about credit valuation adjustment (CVA) in derivative pricing. It describes a simplified setup in which the transaction’s actual price is the base price plus CVA, with the base price calculated using standard assumptions such as a risk-free discount rate. It also states that CVA is typically negative when a bank faces a low-rated, uncollateralized counterparty.

The author asks whether this arithmetic means the bank offers the derivative at a cheaper price, despite the perceived higher cost of taking counterparty credit risk. The document provides no explanation or answer, quantitative example, or pricing convention to resolve the apparent conflict. Its usefulness is therefore limited to identifying a common source of confusion: price adjustments can have different signs and interpretations depending on which party’s perspective and which pricing measure are being discussed.

Key ideas

• The document distinguishes a derivative’s base price from a credit valuation adjustment.
• It describes CVA as typically negative for a low-rated counterparty without collateral.
• It asks how to interpret the sign of CVA in a bank’s quoted transaction price.
• The document does not provide an answer or establish the pricing convention needed to resolve the question.

Tags

# How xVA is applied to determine final price


# How xVA is applied to determine final price












Typically, the Actual price is derivative transaction (e.g. Swap) is sum of Base price and xVA e.g. cVA.

Where Base price is analytical price with consideration of standard parameters e.g. risk free rate for discounting future cash flows.

For simplicity, lets assume only valuation adjustment is considered as cVA, and typically it is negative.

Therefore if a Bank is transacting such derivative contract with a low rated counterparty without any collateral consideration (e.g. end user), typically cVA will be Negative.

So given that Actual price = Base price + cVA, and cVA is negative, does it mean that Bank is offering this derivative in cheaper price?

I felt this is counter-intuitive, and such transaction should be costlier.

Is there something I am missing terribly in xVA understanding.

Any intuitive explanation will be very helpful.

Shown in full with attribution under the source's licence. Licence: CC BY-SA 4.0 (Stack Exchange)

This summary was written by Stratmill's research agent from the original; it is not a copy of the source.