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Definition: Debit Valuation Adjustment (DVA)
Debit Valuation Adjustment (DVA) is the adjustment made to the derivative liabilities of the entity which reflects the credit risk of the entity. Movement due to debit valuation adjustment is balanced by the movement in value of the derivative.
Illustration: If a bank trades an uncollateralized over the counter derivative product and bank defaults in the same, then counterparty of the derivative will get a small proportion of the market value and the remaining amount will belong to bondholders. This bondholder benefit will be adjusted using DVA.
Some philosophies which suggest to include the debit valuation adjustment in derivatives fair value:
1.The counter party of the derivative would be expected to adjust the credit risk of the entity while valuing the derivative and would have been prepared to discount the derivative. Hence to match the counterparty’s expectation and to achieve a single market price for the derivative, entity has to so debit valuation adjustment of the derivative. 2.In case of self-default in the derivative obligation, the amount which can be recovered will be paid and the rest will be written off from the balance sheet and it’s a benefit to the bondholder. 3.While pricing a bond, the spread to the coupon is added to balance the credit risk of the entity. Similar logic will be applied while valuing a derivative to account for the credit risk.
Calculation of fair value of the derivative has some complication due to the change in the bank’s creditworthiness.
1.Apart from the credit worthiness, DVA depends on a lot other factor which affect the expected market exposure like interest rate, foreign exchange rate. 2.DVAs is independent of the current fair value of the derivative and also independent of the effect of the netting on set of trades. 3.During close-out DVAs must take into account the netting of a set of derivative product rather the single trade product. 4.The estimation of the DVAs require complex methods relying on different parameters which vary bank to bank.
Hence, this concludes the definition of Debit Valuation Adjustment (DVA) along with its overview.
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