Understanding CVA, DVA, and FVA: Examples of Interest Rate Swap Valuation

Abstract

Financial statements of major money-center commercial banks increasingly include reference to a credit valuation adjustment (CVA), debit (or debt) valuation adjustment (DVA), and funding valuation adjustment (FVA). This article explains the concepts behind CVA, DVA, and FVA using examples of interest rate swap valuation. A binomial forward rate tree model is used to get the value of the swap assuming no default. The CVA (the credit risk of the counterparty) and the DVA (the credit risk of the entity itself) depend on assumptions about the probability of default, the recovery rate and the expected exposure, which depends of projected values and settlement payments for the swap. The FVA arises when an uncollateralized swap is hedged with a collateralized or centrally cleared contract. In this version of the paper, two methods to calculate FVA are shown, both using the same assumptions about the credit risk parameters for the bank.