Fundamentals

Consider a derivative contract such as an Interest Rate Swap, an FX Forward, a Credit Default Swap CDS, etc. Its net present value (NPV) can be positive and negative during its life. If our counterparty defaults while the NPV is positive, then we lose our claim, unfortunately. This is similar to the situation where we lend money to the counterparty, which we might lose in the case of its default. On the other hand, if the NPV is negative at default time, the contract is not just terminated but the counterparty’s claim to us persists, and the counterparty’s liquidator will request full compensation for it. It is centuries-old practice in the loan business to ask for an extra margin in order to compensate the lender for the expected loss based on the borrower’s creditworthiness. The equivalent compensation in the derivatives context is CVA. If we denote the default risk-free value as NPV then we write the default-risky value subtracting the CVA, that is defining it as the compensation to ask for.