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Abstract
The concept of credit valuation adjustment (CVA) has been given a brand new dynamic by the Basel III framework, which introduces a capital charge to cover future changes in exposure -- a present-day reserve for tomorrow's sliding counterparty credit risk. For derivatives that can be centrally cleared, this charge is relatively low, but there are many products that cannot be cleared, creating a strong incentive for banks to reduce the size of the charge. Hedging is currently performed with variants of the credit default swap, which have to be accounted for at fair value, with changes appearing in profit and loss (P&L). Looking solely at the accounting numbers, it appears a bank hedging the Basel III CVA risk charge is actually a net protection buyer. The counterintuitive outcome is that a widening of credit spreads will generate positive P&L, increasing equity under International Financial Reporting Standards (IFRS) and consequently boosting regulatory equity so long as IFRS also forms the basis for regulatory capital.