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Credit Valuation Adjustment or CVA is the market price of credit risk on a financial instrument that is marked-to-market, typically an OTC derivative contract. Hence CVA is defined as the difference between the price of the instrument including credit risk and price where both counterparties to the transaction are considered free of credit risk,

(2.6)

Note that as defined in equation (2.6) CVA will always be positive if we consider only the credit risk of the counterparty. This sign convention is the one often used by CVA management functions; however, note that the accounting impact of the same number is negative as in this case the credit risk reduces the value of the derivative so that

There are a variety of different models for CVA and the market uses models in which only the credit riskiness of the counterparty is considered (unilateral), and models in which the credit worthiness of both counterparties is considered (bilateral).

Bilateral CVA models add an additional term, Debit Valuation Adjustment or DVA that arises from the credit risk of the reporting institution. As the credit worthiness of the institution declines, usually marked through widening CDS spreads, the institution books an accounting gain on its derivative portfolio, with the gain reflecting the fact that should the reporting institution default it will not fully repay all its obligations. DVA is a very controversial topic as it acts to increase the accounting value of a portfolio of derivatives at the same time that the credit worthiness of the institution is declining. There is also considerable debate around whether DVA can be effectively hedged or monetised.

There are in fact two types of DVA appearing in accounts, derivative DVA, as described above and debt DVA that arises when an institution opts to fair value its own issued debt. In this case the institution books an accounting gain when their debt declines in value. In theory the institution could buy back the debt thus crystallising the gain, although in practice this does not often happen. The institution is unlikely to have funds available to buy back debt in such a scenario.

CVA was introduced as a financial reporting requirement under FAS 157 issued in September 2006 by the Financial Accounting Standards Board (FASB) and coming into force for all entities with fiscal years beginning after 15 November 2007. The requirement to consider credit risk was also introduced by the International Accounting Standards Board through IFRS 39 (IASB, 2004) that was endorsed by the European Commission in 2005. IAS 39, unlike FAS 157, did not explicitly state that own credit risk should be taken into account (McCarroll and Khatri, 2011). This was subsequently changed in IFRS 13 (IASB, 2012) and IFRS 9 (IASB, 2014).