CVA, DVA, LVA, FVA, CSA

and
What else?
Christian Kamtchueng
CTK.corp
London,UK

ESSEC
Paris,FRANCE

christian.kamtchueng@gmail.com

First version: Nov 20, 2012

This version: Jan 3, 2013

Abstract
It was upon a time, the Risk Neutral pricing world. Under this world every payoff ac-
tualized was a martingale. The industry became more and more complex but still managed
to provide prices for exotic, indeed via a Monte Carlo Method almost everything was pos-
sible under this measure. After Lehman Brtothers defaults, the practitioner realized that
the assumptions of this world were more important than the consequences of this magical
world. The world was easy and the price fair but the market was not complete (far to be
complete) ! It is not that the industry was not aware, it is just that it was easier and theo-
retically more beautiful to ignore some assumptions than make the uniqueness of the price
disappears. Indeed how can we be sure of our pricing methodology if prices are not unique.
Only some braves went to this road but the market is more powerful than any individual
The opinions of this article are those of the author and do not reflect in any way the views or business

of his employer.

Electronic copy available at: http://ssrn.com/abstract=2235637

 2

theory or conviction (it doesnt matter if you are right alone). In this article, which is part
of an on going book, we established the base of the New Pricing Theory. The industry opts
for adjustment of the traditional risk neutral price; CVA,DVA,FVA,LVA are part of the
new pricing standard. The debate is not settled and many points of views are still open
to discussion. We will first define the new adjustments, respecting all literature points of
views then highlight our vision and the consequences in matter of pricing.

Keywords: CVA, DVA, FVA, LVA, CSA

Electronic copy available at: http://ssrn.com/abstract=2235637

 3

Contents
1 Introduction 4

2 CVA 4

3 DVA 4

4 LVA 5
4.1 FVA . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
4.2 Market Liquidity Value Adjustment . . . . . . . . . . . . . . . . . . . . . . . . . 6

5 CSA 6

6 New Pricing Theory 7

7 Numerical Result and Comments 8

8 Conclusion 11

9 FVA Strategy 13

10 Results For Synthetic Forward 14

10.1 Buyer-Seller Identity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
10.2 Adjustments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14

11 Treasury Arbitrage at t0 16

12 Treasury Arbitrage at T 19

13 FVA Market Proxy Strategy at time t0 20

14 FVA Market Proxy Strategy at Maturity 21

15 FVA Market Proxy Strategy before Maturity 22

Electronic copy available at: http://ssrn.com/abstract=2235637

 4

1 Introduction
In a world not so far from now, the financial industry used to price under the risk neutral
measure. Under this wonderful and theoretical world, every contingent claim actualised was
a martingale. More than this everything seems feasible. Indeed this martingale property
gives the ability to price an infinite number of exotics. The market was confident on this
Wonderful world based on the so efficient Pricing Theory. Some of the market participants
forgot the major assumption of this world. The completeness of the market is not guaranteed,
in fact the market is far to be complete. When Lehman defaulted, the lack of liquidity and
the default fear pushed the industry to reconsider this common assumption. The market
was not liquid enough and adjustments were needed. First the CVA became standard then
academicians and practitioners started debating about DVA and FVA, at the end LVA was
added too. The discussion is still on going 5 years after the default of Lehman Brothers.
We will first define these adjustments then we will illustrate the industry point of views via
concrete pricing example. Finally we introduce to our vision of the New Pricing Theory.
Our main result is to established the new pricing rules of this new default world; the Fear
Pricing Theory. Compare our views to the past methodology and to others vision.

2 CVA
The CVA became a standard after Lehman defaults, the lack of confidence between market
participants pushed the industry to react. The risk neutral price has been adjusted by the
CVA which can be considered as a default option (the notion of premium is debating in [9]).
The classical definition of the CVA for a portfolio , CV A
(AB) , is the following:
"Z #
T Rt
rs ds
+

CV A
(AB) = EQ (1 R) e t0
t dQ ( < t)
t0
T r ds
h R i
= EQ (1 R) e t0 s + T

Remark: this definition does not take into account the hedging strategy adopted to hedge our
CVA, in fact some cost should be added regarding the trading constraint of the CVA trading
desk.
Note: the purists used to the classical theory could see in the second definition an obvious
pricing solution of the CVA. Indeed if the exposure is liquid enough, we could refer to the
martingale property of the contingent claim actualised.

3 DVA
The DVA definition is related to the CVA definition as follows:
DV A
(AB) = CV A
(BA)
 5

In [7] and [8], Kamtchueng consider the structure P = P CV A(AB) with B seller the option
to A. He mentioned that the structure is not hedge able for B. Indeed P can be rewritten as
P = P DV A(BA) . He is not in favor of the theoretical hedging strategy described in [15],
which consists to buy back its own bound. Can you incorporate in your price the risk of
someone else? If this counterparty sees this risk, it should ask to be compensated for it but
we can ask the seller to consider a price adjusted by a risk which is not concerned but more
than this which is not hedge able.
The DVA by symmetry with the CVA is another option which covers against the default of
the counterparty. In our example B can sell it to A. It is not an adjustment of the price of A.

4 LVA
The Liquidity Valuation Adjustment has been introduced in order to take into account the
liquidity risk resulting of funding and market liquidity issues. During the subprime crisis,
the market started to decrease in volumes dramatically. Because of the default fears, market
participants were less risk appetite or more realistic concerning the default risk.
Lot of financial institutions were stuck with some so called toxic assets; credit portfolio
composed by credit derivative structures such as CDS, CDO, CDO2 and other basket default
swaps. This market very liquid and dynamic became suddenly dead. It was not only a credit
market freezing, but resulting of the huge exposure of the major market participants in this
lucrative business, each of this institution became to be very suspicious concerning the
position of the counterparty and its solvability.
This fear was expressed directly via the basis spread market; spread negligible pre-Lehman
default started becoming significant enough. The market started considering a credit risk
into this product which is systemic because no one is too big to default but also idiosyncratic
because each institution has its own default identity (fundamentally based but also market
based via the bond and the CDS market).

4.1 FVA
The FVA has been a huge problem after the subprime crisis, source of debate, its definition
itself is not well established. The debate has been focus on it consideration in the pricing.
In [18], Kamtchueng consider a risky F V A (which incorporates the idiosyncratic funding
spread)

rA = r + sfA
sfA = sL + sA

In order to avoid double counting, the part of the industry in favor of the DVA considers a
risk free DVA (no idiosyncratic risk) or systemic FVA see Morini and Co.
We have to distinguish the risky FVA to the default risky FVA. Indeed the default risky FVA
consider a default risk in the pseudo funding strategy. It is very problematic to consider
 6

this type of FVA, indeed we do not consider the change of spread in case of default. As
mentioned in [19], the perception of default happens before the actual default.

 f

B t sfB , sB

By considering the market proxy FVA described in [18], the strategy supposed our funding
exposure liquid enough to be able to buy it today via a collateralized trade with a premium
fund via a loan from our treasury (see graph in Annexe). The loan maturity is the maturity
of our trade, therefore we are not sensitive to a default as the position are fixed from today.
If your strategy is based on a roll over of loan conditioning of default, your FVA value will
be impacted by the change of funding spread in the future. The elasticity and inelasticity
assumption may play a big part on the evaluation of this FVA which would be more time
consuming.
The strategy described in [18] by Kamtchueng based on a long term loan is a market strategy
model independent (no sensitive to the elasticity, inelasticity assumption).

4.2 Market Liquidity Value Adjustment

The funding risk is a sub set of the liquidity risk. Indeed the LVA is also composed by Market
Liquidity risk.
In [19], Kamtchueng established a way to fully liquidity adjust the CVA close out price. Ap-
plying this methodology to the premium will allow us to adjust the price to the liquidity
market. Indeed as the FVA, the LVA is not a premium, it is an actual cost. Therefore the
mathematical definition proposed by Kamtcueng is suggestive. The computation measure is
not clear (except for the market proxy which is an actual price related to an actual hedge).
This term is a real problem because we can not consider it within a risk neutral framework.
The LVA (resp FVA) is vision dependant; the seller has to decide for a relevant quantification
of this risk.
Remark: we do not take into account any funding benefit in our definition of the LVA (MLVA
and FVA).

5 CSA
In order to reduce their exposure to a counterparty default, the market participants agree for
an exchange of collateral at each call period.
This procedure is supposed to reduced the credit risk, however we have to remark that it is
not necessary always the case (see numerical example for instance).
In addition collateral management is a cost which can not be afforded by every institution.
Quantitative issues are also observed, such as
 7

no cash collateral and Wrong Way Risk

implicit currency option
lack of standard in the CSA

6 New Pricing Theory

The adjustments defined in the previous section, leave the industry in a new world without
any standard except their own risk appetite, fear of default and lack of confidence. The only
certainty of the market is its uncertainty. The crisis shows us the weakness of the system,
and how a credit market supposed to prevent or cover us against the default become a bubble
causing them. More than the bubble usually imputed to the industry kindness regarding the
short term fees against mid term losses, we see the defiance of different market indicators
such as the credit rating.
As mentioned, the debate is still ongoing. Some authors stand and want to adjust the risk
neutral price and retrieve some risk neutral property as the uniqueness.
Our positions are the following:

We do not considered no hedge able benefit adjustment in our pricing. The DVA also
seen as funding benefit can not be considered in our pricing definition
The FVA is very problematic because not necessary hedge able, this term is subject to
the seller point of view. It could be a risk measure such as a VAR

Remark: Some authors are against the FVA adjustment but are in favor to the DVA adjust-
ment which is considered as a funding benefit.
Instead to list the different positions in the literature, we would like to consider the implica-
tion of our view on the entire market.
The disparity resulting of the added adjustment will force the institutions to negotiate and
reduce the costly speculation position. Indeed, the price before the crisis was buyer-seller
relative.
Post Lehmans default, the price is impacted by who is selling and who is buying.
Remark: the collateral trade is function of the collateral type and the CSA term.

P = P + CV AP + DV AP
P = P + CV AP + DV AP + F V AP
P = P + CV AP + F V AP

By taking into account the seller and buyer identities, we have:

 
P(A) = P + CV AP
(AB) (sc
B ) + DV A P
(AB) (sc
A ) + F V A P f
(AB) sA
 8

Before the 2007 crisis, the Pre-Lehman Pricing Theory so called classical theory was ques-
tionned and subject of discussions concerning the derivatives and the ill calibration problem
(pricing model, calibration method, hedging instrument, and hedging strategy).
Few academicians were aware about the liquidity adjustment done to the risk neutral price
at the trading level (see [19]).
After Lehman defaulted, the so called New Pricing Theory (fear pricing theory) considers
some adjustments:

CVA: although market participants can agree a consensus regarding the counterparty
credit spread term structure, the computation of the CVA number varies according to
different factors. Indeed it is related to the pricing valuation of the derivative in the
future and the simulation of risk factors constituent of a state of the world.
DVA: by considering the CVA definition of the DVA, we have a similar observation.
LVA:

FVA: is a function of the funding spread, controversial the FVA definition itself
is not clear; Kamtchueng in [18], illustrated the matter. He presented a static
replication of the FVA in a particular case but established that this term has no
reason to be considered under a specific measure because of it is no hedge ability.
It can be interpreted as a risk charge without any measure restriction (excepted
the ones from the risk management).
LVA market or Market Liquidity Adjustment (MLA): has been established before
the crisis. The stress market and cautious environment post Lehman default push
the quants to be more involved in the computation methodology of this risk. In [?],
Kamtchueng propose an uncertain valuation method and a classical one based on
the hedging entry cost.

CSA: the multiple frictions linked to a CSA, imply a huge quantitative considerations
and discussion. Indeed the real risk neutral rate could be one day considered as the RO-
NIA but without any consensus about the type of CSA, the quant are forced to consider
it at the one to one basis.

7 Numerical Result and Comments

We have computed the adjustment related to a Synthetic Forward (long call position and
short put position) between two counter parties A and B which are identified via their default
term structure (see Figure 1).
In Tables 1 and 2, we established the adjustment as function of different point of views; A
seller (to B), B seller (to A), A buyer (from B) and B buyer (from A).
We retrieve the CVA - DVA relation, indeed as we can see in the Tables 1 and 2, the CVA
applied by A to B on his long position (resp short) on a Synthetic Forward is equivalent to
minus the DVA applied by B to A on his short position (resp long) on a Synthetic Forward.
 9

We can notice the negligible Monte Carlo error.

We do not consider the MLVA, the main reason is that it was already applied before the crisis
and unlike the FVA can not be subject to debate. In [19], Kamtchueng described methods to
quantify the market liquidity risk

delta hedging cost to entry (dynamic hedging)

vanilla market replication static

uncertain volatility (dynamic hedging)

Some of these methods can be combined.

As the MLVA, the FVA is problematic because dependents of the institution risk apetite. If in
[18], a risk neutral replication of the FVA is proposed, this methodology assume the liquidity
of the funding exposure in the option market. In addition, we are sensitive to residual risk,
credit risk depending of the CSA term and still FVA resulting of the cash flows exchange from
our CSA (see Figure 4).
In Table 3 and Figure 2, We can see that without CSA, A and B can find a consensus given
they share the same view regarding the adjustment consideration.
In Figure 3, we can see the impact of our FVA choice on the bid ask spread (without CSA).
In Table 4 and Figures 5-7, an increase of the bid-ask spread in the case of CSA can be
observed. In fact nothing is lost, but just transformed by reducing our credit risk exposure,
we increase our need of funding. We can notice also that the order of adjustment is not the
same, which is link to the contingent claim but also to the CSA term (we have a bi monthly
collateral margin call).
Details in the market context are given in Appendix Results for Synthetic Forward.
We do not consider the M LV A in sense that it is not subject to debate, even if as the FVA its
determination varies from a firm to another (see [19] for more details).

No CSA
Adjustment

type CVA DVA FVA FVA-VAR

A-seller 0.9148 -0.2166 5.9404 24.808

B-seller 0.6413 -0.3086 8.8978 35.527

A-Buyer 0.29313 -0.6618 12.845 119.16

B-Buyer 0.22475 -0.9482 19.135 180.45

Table 1: Synthetic Fwd Adjustment without CSA, strike = 120, Maturity 2Y

 10

CSA
Adjustment

type CVA DVA FVA FVA-VAR

A-seller 0.37651 -0.26302 1.99645 16.239

B-seller 0.26796 -0.3770 3.01089 23.7479

A-Buyer 0.372917 -0.26767 2.0297 20.959

B-Buyer 0.26830 -0.38685 3.08831 30.5143

Table 2: Synthetic Fwd Adjustment with CSA, strike = 120, Maturity 2Y

No CSA
Adjustment
A B
type seller buyer seller buyer

CVA 0.9148 0.2931 0.6413 0.2247

CVA-DVA 0.6982 -0.368 0.3327 -0.723

CVA-FVA 6.8552 13.134 9.5386 19.360

CVA-FVAVAR 25.723 119.46 36.168 180.68

CVA-DVA-FVA 6.63865 12.4728 9.2300 18.412

CVA-DVA-FVAVAR 25.507 118.80 35.86 179.73

Table 3: Pricing Bid Ask without CSA

CSA
Adjustment
A B
type seller buyer seller buyer

CVA 0.3765 0.3729 0.2679 0.2683

CVA-DVA 0.1134 0.1052 -0.109 -0.118

CVA-FVA 2.3729 2.4021 3.2788 3.3566

CVA-FVAVAR 16.615 21.332 24.015 30.782

CVA-DVA-FVA 2.1099 2.1345 2.9018 2.969

CVA-DVA-FVAVAR 16.352 21.064 23.638 30.395

Table 4: Pricing Bid Ask with CSA

 11

8 Conclusion
In order to move forward, the market reacts to the crisis by adjusting the risk neutral price.
We described this new context via a numerical example.
The changes are real and significant, whatever the market choice of standard.
Indeed the consensus seems reachable in the case of no CSA and given the use of the same
methodology. There is still place of negotiations regarding the institutions utilities.
The CVA, CVA-DVA seems convenient for the order of the adjustment. The first one do not
consider the funding risk, and the second consider a funding benefit without practical hedge.
How can we quantify a no hedge able risk?
The lack of equilibrium will force market participants to reduce any speculative position
(which will imply a expensive cost of entry and a breach of risk limits).
The CSA imply generally a reduction of the default risk. In our results we see that this
reduction depends also of the agreement terms. The exposition does not decrease necessarily,
therefore also the adjustments.
Bid-Ask-Buyer-Seller spread can be huge depending of the funding exposure and the risk
appetite of the firm.
The implications are vast; the new bid-ask-buyer-seller spread will force the market partici-
pant to be more cautious.
The market can come back to a mid price old fashion or goes to negotiation standard.
Our result shows a need of standard for the CSA in order to consider the risk linked to the
risk collateral (for instance a government bond).
 12

References
[1] M.Avellaneda, A.Levy, A.Paras, Pricing and Hedging in Markets with Uncertain Volatil-
ity, (1995)

[2] C.Kamtchueng, Digital Pricing and Hedging, (2009)

working paper

[3] S.Alavian,J.Ding, P.Whitehead, L.Laudicina, Credit Valuation Adjustment, (2010)

working paper

[4] Y.Elouerkhaoui, Trading CVA: A new development in correlation modelling, (2010)

Working Paper

[5] D. Brigo, M. Morini, Dangers of Bilateral Counterparty Risk: The Fundamental Impact
of Closeout, (2010),
Working Paper

[6] V.Piterbarg, Funding beyon discounting: collateral agreements and derivatives pricing,
(2010),
Risk Magazine

[7] C.Kamtchueng, CVA Implied Vol and Netting Arbitrage, Introduction, (2010)
working paper

[8] C.Kamtchueng, CVA Implied Vol and Netting Arbitrage, (2010)

working paper

[9] C.Kamtchueng, CVA premium or charge? Call Hedging, (2011)

working paper

[10] C.Kamtchueng, Uncertain Monte Carlo, (2011)

working paper

[11] T.R.Bielecki, S.Crepey, M.Jeanblanc and B.Zargari, Valuation and Hedging of CDS
Counterparty Exposure in Markov Copula Model, (2011)
Working Paper

[12] S.Alavian, Funding Value Adjustment , (2011),

Working Paper

[13] C.Fries, Discounted revisited. Valuation under funding, counterparty risk and collateral-
ization , (2011),
Working Paper
[14] C.Kamtchueng, Smile Perfect Match Extension, (2011)
working paper

[15] C.Burgard, M.Kjaer, CVA and FVA with funding aware close outs , (2012),
Working Paper
 13

[16] J.Hull, A.White, The FVA debate continued , (2012),

Working Paper

[17] A.Castagna, Yes, FVA is a Cost for Derivatives Desks - A Note on Is FVA a Cost for
Derivatives Desks? by Prof. Hull and Prof. White, (2012),
Working Paper

[18] C.Kamtchueng, FVA Modelling and Netting Arbitrage, Introduction, (2013)

working paper

[19] C.Kamtchueng, Fully Liquidity Adjusted CVA, (2013)

working paper

9 FVA Strategy
The FVA is subjected to discussion regarding its definition and its relevance as pricing ad-
justment. We have implemented the following FVA methodologies:

SF wd
F V A : Market Proxy defined in [18], see Figure for more details

F V ASF wd : Standard Method estimate via a Monte Carlo, it is expectation of the our
funding impact.

F V ASF wd V AR: VAR Method, it is a percentile of the previous Monte Carlo Method (99%
in our tests).

No CSA
Adjustment

type ASF wd
FV F V ASF wd F V ASF wd V AR

A-seller 1.9107 5.9404 24.808

B-seller 3.3827 8.8978 35.527

A-Buyer 5.7194 12.845 119.16

B-Buyer 10.1256 19.135 180.45

Table 5: FVA for Synthetic Fwd without CSA, strike = 120, Maturity 2Y
 14

10 Results For Synthetic Forward

10.1 Buyer-Seller Identity

We have considered two entities A and B characterized by their probability of default term
structure.
1.0

0.8
Default Prob

0.6

0.4

0.2

- A Default Prob
- B Default Prob
0.
0. 0.5 1.0 1.5 2.0

Figure 1: Default Probability Term Structure

10.2 Adjustments
We have the following market prices at time 0, for a maturity T = 2Y and strike K = 120:

St0 = 150

S := V0 = 0.3, V = 0.25, k = 1.4, V = 0.3, = 0.84



r := {r0 = 0.03, a = 1, b = 0.03, r = 0.1}

zA := {z0 = 0.05, a = 0.13, b = 0.25, z = 0.1, z = 0.2}

zB := {z0 = 0.09, a = 0.12, b = 0.24, z = 0.09, z = 0.2}

zEco := {z0 = 0.015, a = 0.023, b = 0.035, z = 0.02, z = 0.03}

t := zt + z rt

Call (T, K) = 55.525

P ut (T, K) = 18.549

SF wd (T, K) = 36.975

Df (T ) = 0.941
 15

Df A (T ) = 0.858

Df B (T ) = 0.803

Adjustment numerotation:

1. CVA

2. CVA-DVA

3. CVA-FVA

4. CVA-FVAVAR

5. CVA-DVA-FVA
6. CVA-DVA-FVAVAR

1.0

0.8

0.6

0.4

0.2

0.
1 2 3 4 5 6 7

0.2

0.4

0.6

0.8

1.0

Figure 2: Pricing Bid Ask

 16

17.5

12.5

7.5

2.5
0. 1 2 3 4 5 6 7
Figure 3: Pricing Bid Ask, FVA

11 Treasury Arbitrage at t0
 17

175

150

125

100

75

50

25
0. 1 2 3 4 5 6 7
Figure 4: Pricing Bid Ask, FVAVAR

0.4

0.3

0.2

0.1

0
1 2 3 4 5 6 7

0.1

Figure 5: Pricing Bid Ask with CSA,

 18

2.
0. 1 2 3 4 5 6 7
Figure 6: Pricing Bid Ask with CSA, FVA

31

30

29

28

27

26

25

24

23

22

21

20

19

18

17

16.
0. 1 2 3 4 5 6 7
Figure 7: Pricing Bid Ask with CSA, FVAVAR
 19

12 Treasury Arbitrage at T

Figure 8: Arbitrageable Treasury at t0

 20

13 FVA Market Proxy Strategy at time t0

Figure 9: Arbitrageable Treasury at Maturity

 21

14 FVA Market Proxy Strategy at Maturity

Figure 10: FVA market strategy at t0

 22

15 FVA Market Proxy Strategy before Maturity

Figure 11: FVA market strategy at Maturity

 23

Figure 12: FVA market strategy before Maturity