In the latest issue of Risk.net magazine, esteemed professors Rama Cont$$^{\dagger}$$ and Riccardo Rebonato$$^{\ddagger}$$ took part in a panel discussion where they questioned the legitimacy of using credit value adjustment (CVA) $$-$$ a method used to incorporate counterparty credit risk when pricing derivatives.

When calculating CVA of a bilateral contract it is assumed that the default probabilities of the two parties, their joint-default probability, and their recovery rates are all known. As Cont argues there is no possibility that institutions can estimate these values with any degree of precision which could beg the question $$-$$ why are we using it?

Rebonato continues to further questioning the usage of CVA calculations by saying that the usage of CVA somehow has become an industrywide standard acceptable by regulators. And by using it, institutions counterparty risk is considered controlled granting them a certain amount of capital relief.

Unarguably, incorporating counterparty risk is a vital part when evaluating credit risk. However, whether or not CVA is the best method to do so seems to be up for debate.

$$\dagger$$ Professor of mathematics and chair of mathematical finance at Imperial College London, UK.
$$\ddagger$$ Professor of finance at Edhec Business School, France.

Risk.net