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Why CVA and DVA Apply to Derivatives Rather Than Bond Portfolios

Article Quant Q&A · Author: d0whes
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Summary

The document explains the distinction between credit valuation adjustments on derivatives and credit risk in a bond portfolio. Its answer says CVA and DVA are adjustments to a derivative’s fair value for costs and risks associated with the counterparty. A bond’s issuer credit quality, by contrast, is already reflected in its market price, so the answer does not treat CVA as an additional adjustment to a sovereign bond portfolio.

The question also raises whether default probabilities inferred from CDS spreads can be used in this setting. The response does not develop that calculation or discuss how to estimate CVA or DVA, calibrate probabilities, or handle sovereign exposures. Its main lesson is conceptual: reference-entity credit risk in a bond and counterparty risk in a derivative enter valuation differently. The explanation is brief and does not address specific contractual structures or cases where additional adjustments might be considered.

Key ideas

  • CVA and DVA are presented as adjustments to derivative valuations for counterparty-related costs and risks.
  • A bond’s issuer credit quality is reflected in its price, according to the answer.
  • The response distinguishes bond issuer risk from derivative counterparty risk.
  • It does not explain how to derive or apply default probabilities from CDS spreads.

Tags

Fixed incomeDerivatives pricingRisk management
Full text
# Can I calculate the CVA or DVA over a sovereign portfolio?


# Can I calculate the CVA or DVA over a sovereign portfolio?












Hi I haven't understood if I can apply the CVA just for derivatives or I can estimate the PD from CDS spreads and apply these in a bonds portfolio for the CVA calculus. The CVA literature refers to "counterpart risk", but if I use the PD calculated from the CDS spreads I've the "reference entity risk", can I use this one for the CVA/DVA estimations? Thanks, sorry for my banality.

## Answer by David Duarte (score 4)

https://quant.stackexchange.com/a/54816

CVA stands for Credit Valuation Adjustment and should be applied to derivatives and not bond portfolios.

The reason is that unlike derivatives, a bond has the counterparty credit quality implicitly priced. Consider two bonds with exactly the same features (coupon, maturity, etc) but issued by a different entity. Most likely, the bonds will have different prices.

The fair price of a derivative on the other hand ignores who the counterparty is, and that is why all the xVAs came abount. They are valuation adjustments to the derivative's fair value to take into account all sorts of costs that the "holder" of a derivative will bear.

So a bond has the counterparty risk implicitly priced and a derivative can have the counterparty risk explicitly priced through CVA/DVA.

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.