XVA
An X-Value Adjustment (XVA, xVA) is an umbrella term referring to a number of different “valuation adjustments” that banks must make when assessing the value of derivative contracts that they have entered into. The purpose of these is twofold: primarily to hedge for possible losses due to other parties' failures to pay amounts due on the derivative contracts; but also to determine (and hedge) the amount of capital required under the bank capital adequacy rules. XVA has led to the creation of specialized desks in many banking institutions to manage XVA exposures. Context Historically, (OTC) derivative pricing has relied on the Black–Scholes risk neutral pricing framework which assumes that funding is available at the risk free rate and that traders can perfectly replicate derivatives so as to fully hedge. This, in turn, assumes that derivatives can be traded without taking on credit risk. During the financial crisis of 2008 many financial institutions failed, leaving their counterparts with claims on derivative contracts that were paid only in part. Therefore it became clear that counterparty credit risk must also be considered in derivatives valuation, and the risk neutral value is to be adjusted correspondingly. Valuation adjustments When a derivative's exposure is collateralized,