I am looking at a report by a bank and it say’s that their present value of CVA adjustment has decreased quite significantly…so basically, they’re saying that the value of the counterpart credit risk is smaller than in the beginning of the year. At the same time, the interest rates have increased.
The CDS’s (ItraxxMain 5Y, ITraxxFinancials 5Y and Itraxx XOver 5y) are all up this year by 17-73bps.
Does this make sense? Should the bank want to hedge it’s counterparty exposure by using CDS’s, they would be paying more for it than in the beginning of the year, not less…right?
Is there any other explanation to this?
If default risk decreases the cost of hedging will decrease.
If you look at the formula of the premium to be paid by the CDS buyer who wants to hedge his credit risk exposure or profit from increasing default risk price by the spread you will understand: premium=(CDS spread - fixed coupon) * effective spread duration
If default risk decreases, CDS spread decreases and the premium to be paid by the credit protection buyer decreases that is the cost of hedging…
Moreover, the fact that interest rate rose during the period should not be taken into consideration in the CDS price (see the formula above).