CVA has a specific capital charge under Basel III, and may also result in earnings volatility under IFRS 13, and is therefore managed by a specialized desk.
CVA is one of a family of related valuation adjustments, collectively xVA; for further context here see Financial economics § Derivative pricing.
This price adjustment will depend on counterparty credit spreads as well as on the market risk factors that drive derivatives' values and, therefore, exposure.
is the future value of one unit of the base currency invested today at the prevailing interest rate for maturity
These probabilities can be obtained from the term structure of credit default swap (CDS) spreads.
Assuming independence between exposure and counterparty's credit quality greatly simplifies the analysis.
is the risk-neutral discounted expected exposure (EE): The full calculation of CVA, as above, is via a Monte-Carlo simulation on all risk factors; this is computationally demanding.
[5] [9] The CVA charge may be seen as an accounting adjustment made to reserve a portion of profits on uncollateralized financial derivatives.
These reserved profits can be viewed as the net present value of the credit risk embedded in the transaction.
Thus, as outlined, under IFRS 13 changes in counterparty risk will result in earnings volatility; see XVA § Accounting impact and next section.
The hedging here focuses on addressing changes to the counterparty's credit worthiness, offsetting potential future exposure at a given quantile.