credit risk - How do right-to-break clauses affect CVA calculations

Does the presence of a optional/mandatory right-to-break clause affect CVA calculations, and if so, how?

Given two (otherwise identical) 10y swaps with the same counterparty, one of which has a right to break at 5y (ours), intuitively I'd say the one with the break clause should have a lower CVA - if the counterparty default spread takes a dive we can exit the trade at replacement cost. The question is how do we take that into account when calculating CVA?

Definitions:

• 
  

  For the banks I deal with, when a break event occurs (regardless of whether the break was optional or mandatory) the trade is marked to market, a payment is made to whichever party is in the money & the trade is ripped up.

  
  


• 
  
  

  Trades with a mandatory break are often "replaced" with a similar trade. That might be because a counterparty isn't allowed to have a 20Y trade on their books, for example.

  
  

Answer

The presence of a mandatory break in a swap contract should reduce the CVA charge. That's because the CVA calculation models the default probability* swap market value while the swap is alive, so the calculation stops at the break date. There is one caveat: if a bank has a history of "waiving" mandatory breaks (i.e. In practice they never get exercised ) then the regulators can challenge his treatment. That would be a bank by bank discussion. So if you put one in, be prepared to execute it.

To clear up any confusion, a mandatory break is satisfied at the then market value, typically as determined by s panel of banks ( this needs to be specified in the confirm).

Optional breaks: if a counterparty grants a bank an optional break then then theoretically it should reduce the cva charge as for the mandatory breaks. However the implication is that on the break date either the break is exercised or the bank must demand a further cva charge to continue the swap (even if client credit is not impaired in any way). The cva desk may believe it will be unable to collect this value or even to execute the break against a valuable client. Hence the optional break may not achieve the full cva charge reduction at many banks.