How is bilateral credit risk measured on an uncleared swap? What are CVA and DVA?

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AcadiFi · Accepted Answer

Bilateral credit risk exists because either counterparty can default. CVA (Credit Valuation Adjustment) is the expected loss from counterparty default; DVA (Debit Valuation Adjustment) is the expected gain from your own default (morbidly, a liability write-down).

Fair value of a swap under bilateral risk: V_risky = V_riskfree - CVA + DVA.

Example: Brindle Energy has a 7-year swap with Korvis Bank. Brindle's expected positive exposure (EPE) to Korvis averages $4.2M; Korvis's 5-year CDS spread is 140bp; recovery is 40%. Default probability ≈ 140bp / (1-40%) ≈ 233bp/yr. Over 7 years, cumulative PD ≈ 15%. CVA ≈ EPE × LGD × PD ≈ $4.2M × 60% × 15% ≈ $0.38M.

Simultaneously, Korvis computes DVA on Brindle's credit (Brindle CDS 220bp). Brindle's DVA might be $0.52M, meaning Korvis sees -$0.52M adjustment. Net bilateral adjustment for Brindle: -$0.38M (CVA) + $0.52M (DVA) = +$0.14M.

DVA is controversial because it implies firms book gains when their credit deteriorates. IFRS 9 requires DVA on derivatives but excludes it from OCI. Post-Basel III, FVA (funding valuation adjustment) and MVA (initial margin) are also added, producing the full XVA stack used by bank trading desks.

How is bilateral credit risk measured on an uncleared swap? What are CVA and DVA?

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