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xVA: DEFINITION, EVALUATION AND RISK MANAGEMENT

Author

Listed:
  • LIXIN WU

    (Department of Mathematics, The Hong Kong University of Science and Technology, Clear Water Bay, Kowloon, Hong Kong)

  • DAWEI ZHANG

    (Goldman Sachs (Asia) L.L.C., 68th Floor, Cheung Kong Center, 2 Queen’s Road, Central, Hong Kong)

Abstract

xVA is a collection of valuation adjustments made to the classical risk-neutral valuation of a derivative or derivatives portfolio for pricing or for accounting purposes, and it has been a matter of debate and controversy. This paper is intended to clarify the notion of xVA as well as the usage of the xVA items in pricing, accounting or risk management. Based on bilateral replication pricing using shares and credit default swaps, we attribute the P&L of a derivatives trade into the compensation for counterparty default risks and the costs of funding. The expected present values of the compensation and the funding costs under the risk-neutral measure are defined to be the bilateral CVA and FVA, respectively. The latter further breaks down into FCA, MVA, ColVA and KVA. We show that the market funding liquidity risk, but not any idiosyncratic funding risks, can be bilaterally priced into a derivative trade, without causing price asymmetry between the counterparties. We call for the adoption of VaR or CVaR methodologies for managing funding risks. The pricing of xVA of an interest-rate swap is presented.

Suggested Citation

  • Lixin Wu & Dawei Zhang, 2020. "xVA: DEFINITION, EVALUATION AND RISK MANAGEMENT," International Journal of Theoretical and Applied Finance (IJTAF), World Scientific Publishing Co. Pte. Ltd., vol. 23(01), pages 1-24, February.
    • Handle: RePEc:wsi:ijtafx:v:23:y:2020:i:01:n:s0219024920500065
    DOI: 10.1142/S0219024920500065
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    References listed on IDEAS

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