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Real-Time Credit Valuation Adjustment and Wrong Way Risk
Real-Time Credit Valuation Adjustment and Wrong Way Risk
Executive Summary
This paper presents a new framework for real-time
credit value adjustment (CVA) and wrong way risk
(WWR).
In contrast to previous studies, the proposed
model herein relies on the probability distribution
of a model filter an optimal estimator that infers
parameters of interest from indirect, inaccurate
and uncertain observations. New measurements
can be processed as they arrive.
Empirical studies indicate that mark-to-market (M2M) values have not been an effective
reflection of the true value of an asset. As a consequence, the International Accounting Standard
(IAS) 139 requires banks to provide a fair-value
adjustment due to counterparty risk. Thus CVA
became mandatory in 2000. However, it received
little attention until the 2008 financial crisis in
which profit and loss (P&L) swings due to CVA
Current Practice
CVA is expected loss due to counterparty default
at any time before portfolio maturity (M2M) P&L.
It uses four components to manage risk:
Portfolio:
Asset
Risk
Proposed Solution
The building blocks to create a real-time CVA
pricing mechanism should factor in multiple
scenarios or market noise, thus enabling CVA
repricing to reflect micro-changes in exposures.
This means assigning counterparty default values
so as to enable effective netting or utilizing credit
lines to offset or hedge default risk.
We propose the following guidelines for creating
a robust tool for real-time credit risk valuation.
Trade Positions
(Portfolio Level)
Counterparty Data,
Rating
Market Reference
Data
Hedge Trades
(Single Name/Index)
LGD/PD/Recovery
Rate
TRADE SCOPING
Identify Models for CVA
(STD/Advanced)
Assign Guarantors
Assign Hedge
Books to Trades
STAGING
ETL
Finance Reporting
Level Information
Bucketing Based on
Region, Industry & Rating
Bootstrapping to
Generate Proxy Spreads
for All 65 IMM Tenors
CORE CALCULATION
Assign System
Parameters
Define Bucketing
for Proxy Spreads
Figure 1
Expected Exposure
CEM Trades
DATA
SOURCES
Credit Lines
CSA Annexure/
ISDA Agmts
Expected Exposure
(IMM Model)
CVA FLOW
RISK AGGREGATION
Regulatory
Reports
Risk
Managers
CVR Reports
(T+2)
What-if
Analysis
Verify RWA
Aggregation Level
Customized
Reports
Mark-to-Market
Mark-to-market, sometimes known as fair value
accounting, refers to the accounting standards
that determine the value of a position held in
a financial instrument based on the current
fair market price for the instrument or similar
instruments.
IFRS 13 Fair Value Measurement, which is the
latest standard within the International Financial
Reporting Standards (IFRS) framework dealing
with the measurement of fair value, defines
fair value as the price that would be received
to sell an asset or paid to transfer a liability in
an orderly transaction between market participants at the measurement date. The definition
of fair value in U.S. GAAP is consistent. Broadly
speaking, fair value can be estimated using
either a quoted price in an active market
(mark-to-market) or, in the absence of an
active market, a valuation technique based on
observable market inputs and/or recent market
transactions (mark-to-model).
Both U.S. GAAP and IFRS recognize that price
quotations in an active market are the best
evidence of fair value and must be preferred over
other valuation techniques such as mark-to-model
methods. This hierarchy is also encouraged within
IOSCOs policy recommendations for MMFs2.
Under normal market operating conditions, markto-market reflects the values in actual market
transactions between willing buyers and sellers.
There is a single price, transparent to all in the
market. Mark-to-model has meaning only if the
model used reflects the reality of the market. The
is constructed
instead of just one curve. Each curve in the
hierarchy corresponds to a collateralization
type. For example, the root of the hierarchy
typically corresponds to zero credit risk and
is used for discounting all cash flows in the
calibration instruments. Other collateralization
types include LIBOR, etc. However, the trader
can arrange the hierarchy any way they like
and/or add extra collateralization types (e.g.,
for non-USD currencies, currency equivalents
of USD curves can be added and calibrated
against cross-currency swaps). There is no
need for a separate cost of funding anymore.
Each
curve parameters are to be derived via a constrained optimization procedure. The constraints are market prices, and the cost function
of this procedure is user-configurable: it allows
the trader to put in their educated guess of the
next central bank rate moves, the requirements
for curves continuity or (otherwise) jumps, etc.
Mark-to-Matrix
This is a technique used for less actively traded
assets, such as emerging market securities,
municipal bonds and asset-backed securities
(ABS). It involves bootstrapping estimating
a credit spread of the asset relative to a more
actively traded instrument that can be priced
easily.
It
CVA Modelling
Our approach suggests creation or consolidation at two desks, one at the front office level
and the other at the risk management level. The
front office CVA desk needs to be accurate and
extremely fast, given the complexity of analytics,
sensitivities and scenarios. On a parallel plane,
each of these trades must reconcile with all levels
of collateral posted and/or other credit support
documents (CSA) agreements, TPA guarantees,
etc. Often ignored or infrequently valued are
trades of highly rated counterparties. A combination of short dated, collateralized trade along
with other larger exposures must be valued and
monitored in real time.
Several banks have no convergence of systems
and models between front office and risk
management, further compounded by the introduction of new functionality change requests.
To run a thread through each of the existing
functionalities and align these with the black
box algorithms/formulas is time-consuming
and manually driven. In the wake of changes
in technology, new trading venues, collateral
management and valuation and emerging
regulations, many legacy systems have either
become obsolete or are unable to match the
speed in reporting or generating alerts. Often,
this practice of multiple reports from across
legacy, bespoke applications runs the risk of
duplication. With the advent of cloud computing,
several sectors have been completely revolutionized that were once dominated by large
and expensive legacy applications. Thus quick
management alerts are a prerequisite and a vital
tool for effective risk mitigation.
Another area that requires instantaneous data is
the ubiquitous risk management and regulatory
desk arena. Trade level population should have
the same intensity of computation, speed and
accuracy irrespective of the perceived risks
of the trades. An overwhelming majority of
banks rely on Monte Carlo simulation (with
path ranges between 1,00010,000) with
varying time steps. We believe that in addition
to the MC simulation method it would be
prudent to compare the results with that from
another filtration methodology that we call the
champion-challenger model.
We chose the model for its overall simplicity,
the complexity of the inputs, good results in
practice due to its structure, its convenience
for online real-time processing and because it is
The
From
Hedging
Implementation
Front-office systems could be vendor specific
or internal. Since CVA and advanced CVA are
relatively recent, most banks would have systems
in place. We believe that whatever the system
(vendor or internal), real-time pricing ought to
be a standard feature. However, given market
conditions and the ever-evolving landscape,
application functionality (in terms of specification, build and scalability) should be added as
soon as possible. This feature far outclasses a
vendor-based functionality. (In terms of a onesize-fits-all criterion, it becomes extremely
cumbersome to have a third-party system
analyst create a newer version of an existing
application. Customization can create as much
as is required based on requirement/s.)
Risk Mitigation
Risk mitigation, though part of an overall CCR
and not specific to CVA, requires systems and
policies in place such as netting, recouponing
and mandatory break clauses. However, DVA
and collateral (apart from non-mandatory break
clauses) are more subjective and need to be
addressed in real time as well. Credit thresholds
should also be included as part of the mitigation.
Several banks calculate their exposure and creditrelated sensitivities almost daily with advanced
measures/mitigants such as jump to default and
cross gamma apart from traditional delta, gamma
and vega measures/sensitivities. With markets in
financial derivatives (MiFID 2) in Europe placing
restrictions on high speed algorithmic trading
(HSAT), the spotlight is now on the entire gamut
of derivatives as well. We believe that while
hedging would have its limitations (especially if
used to speculate or taken as non-hedge excess
one-side exposure), it also would create a potential
for reducing risk, especially when hedge rebalancing is done. We believe that portfolio valuation
and exposure are directly connected to the hedge
ratio and immediate rebalancing or offsetting of
positions should be made possible through smart
order routing and low latency algorithmic trades.
Though hedging can help risk mitigation and serve
as a profit center, banks must have a model that is
scalable, validated and algorithmically recalibrated in line with changes in macroeconomic data. A
combination of high-speed algos with the optionality of manual intervention should be established
and internal rules governing each strategy must
be laid down and adhered to at all times.
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Conclusion
Regulation in the past was reactive, in terms of
new legislation being passed in the wake of each
disaster. Regulation has now become proactive
a nightmare for banks globally. The G20 grouping
virtually covers 90% of the developed, emerging
world.
With Dodd Frank, CCAR, DFAST, CLAR, CLASS,
AIFMD, MAD, MiFID 2, MiFIR 2 and a plethora of
other regulations threatening to limit the sale or
trade of certain asset classes, investment banking
is under significant pressure.
Footnotes
1
Credit Value Adjustment and the changing environment for pricing and managing counterparty risk,
Algorithmic, 2009. http://www.ey.com/Publication/vwLUAssets/EY-credit-valuation-adjustments-forderivative-contracts/$FILE/EY-Applying-FV-April-2014.pdf
D Brigo, F Mercurio, Interest Rate Models - Theory and Practice, Springer Finance, 2006.
Harvey, AC, Forecasting, Structural Time Series Models and the Model Filter, Cambridge University Press,
1989. http://biorobotics.ri.cmu.edu/papers/sbp_papers/integrated3/kleeman_kalman_basics.pdf
References
F Black, J C Cox, 1976, Valuing corporate securities: Some effects of bond indenture provisions.
Journal of Finance. 31 (1976) 351-367.
D Brigo, K Chourdakis, 2008, Counterparty Risk for Credit Default Swaps: impact of spread volatility
and default correlation, https://www.imperial.ac.uk/people/damiano.brigo/publications.html.
D Brigo, M Morini, M Tarenghi, 2009, Credit Calibration with Structural Models: The Lehman case
and Equity Swaps under Counterparty Risk, https://www.imperial.ac.uk/people/damiano.brigo/publications.html.
D Brigo, A Pallavicini, V Papatheodorou, 2010, Bilateral counterparty risk valuation for interest rate
products: impact of volatility and correlation. https://www.imperial.ac.uk/people/damiano.brigo/publications.html.
D Brigo, M Tarenghi, 2005, Credit Default Swap Calibration and Counterparty Risk Valuation with a
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Acknowledgement
The author would like to thank Saiid Hassanpour Fard, post-graduate doctoral student from the
University of Pune, for his valuable contributions in topology and graph theory in the development of
this white paper.
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