What is the formula for calculating Counterparty Risk using CVA?

The formula for calculating Counterparty Risk using the Credit Valuation Adjustment (CVA) is correctly expressed as CVA = -(EPE * credit spread of counterparty).

In this context, EPE stands for Expected Positive Exposure, which quantifies the average exposure a firm can expect from a counterparty over a specified time horizon. The credit spread of the counterparty reflects the additional yield that investors demand for taking on the credit risk associated with transferring funds or assets to that counterparty.

By using this formula, the CVA effectively captures the potential loss in the case of counterparty default, considering both the expected exposure and the likelihood of the counterparty's credit events, represented by the credit spread. The negative sign in the formula indicates that CVA represents a reduction in the value of the transaction due to risk, which is appropriate since CVA signifies the cost of counterparty risk by its nature.

This approach highlights the essential relationship between credit risk and potential exposures in managing financial risk, illustrating how counterparty risk can impact the valuation of derivatives and other financial instruments.