Chartered Financial Analyst (CFA) Practice Exam Level 2

The term CVA in financial risk management refers to Counterparty Valuation Adjustment. This concept is crucial in measuring the risk of counterparty default in derivatives and other financial transactions. CVA quantifies the potential loss from a counterparty failing to fulfill their contractual obligations over the life of a transaction.

CVA is calculated by considering the probability of default of the counterparty and the potential exposure at default (the loss that would occur if the counterparty defaults). This adjustment is essential in pricing and risk management, as it allows firms to incorporate credit risk into their valuation of derivatives. By using CVA, financial institutions can better understand and manage the risks they are exposed to due to potential defaults, thereby enhancing their overall risk management frameworks.

Understanding CVA is critical for practitioners as it directly impacts pricing, capital requirements, and hedging strategies. It plays a significant role in the broader context of credit risk management practices in financial markets.