Managing Counterparty Credit Risk

:
Implementing Real Time CVA Pricing
Dr. Neil Dodgson
VP Business Development Sell Side
February 2012

© 2012 IBM Corporation

Banking reforms
Risk Management

Finance
IRC

CVA Charge

Stressed VaR

Capital Ratio

RAPM

EPE
VaR

WWR CVA RWA

Credit Exposure
Market Exposure

Basel
III

Fair Valuation
Planning

NSFR
LCR

Collateral
FVA Charge

CVA Price
Front Office

Sensitivities

ALM
Funding
Liquidity

2

© 2012 IBM Corporation

Treasury

How is Basel III affecting counterparty credit risk?  Capital requirement for counterparty credit risk using stressed EPE  CVA calculations  Margin period of risk for collateral management  Central counterparties  Wrong-way risk 3 © 2012 IBM Corporation .

one of Wall Street’s most prestigious firms files for bankruptcy protection . we have seen a shift from passive to more active and continuous management of CCR requiring CVA: Before CVA • Firms apply credit limits and measures such as to limit their possible exposure to a counterparty in the future 1998: Asian crisis and LongTerm Capital Management (LTCM). The unexpected failure of the large hedge fund LTCM and Asian crisis lead to an interest in CCR from some first tier banks 4 Passive Management of CVA Active Management of CVA • Large banks first start using CVA to assess the cost of counterparty risk • CVA is treated via a passive insurance-style approach • The credit crisis and resulting failures of high profile firms generates much more attention on counterparty risk • Banks are interested in more accurate and evermore frequent CVA calculations – daily. IAS 39) mean that the value of derivatives positions must be corrected for counterparty risk All banks must start calculating CVA on a monthly basis © 2012 IBM Corporation Sept. and real-time 2006: New Accountancy regulations (FASB 157. intra-day.CCR/CVA timeline In only a few short years. 10-15. 2008: Lehman Brothers collapses following a reported $4 billion loss and unsuccessful negotiation to find a buyer.

Risk is changing  Before the credit crisis – Most counterparty risk situations were rather unilateral • The “too big too fail” concept obscured counterparty risk • Many institutions see their counterparty as being risk-free (at least from their point of view) • Credit spreads of banks just a few bps • Collateral agreements often one-sided or heavily skewed (independent amounts etc.) – Counterparty risk was the focus of mainly large global banks (1st tier) – Wrong-way risk was a concept rather than a reality – No-one had ever heard of DVA 5 © 2012 IBM Corporation .

Counterparty credit risk .a front office issue Capital Markets Solution for active management of counterparty credit risk Credit exposure calculation • Simulated PFE exposures • Notional and add-on measures • Stress testing • What if analysis FRONT OFFICE /CVA DESK TRADING 6 Limit management • Pre deal limit checking • Trade restrictions & limits • Intra day excess RISK MANAGEMENT © 2012 IBM Corporation CVA calculation • Unilateral and bilateral • Pre-deal incremental CVA • CVA sensitivities FINANCE .

FASB 157) • End of quarter CVA.Counterparty credit risk Users Front office Function • Trading and sales charge clients and customers for CVA. • Trade within limit structures Central CVA Desk Risk Management Finance • Charge trading desks • CVA per counterparty for initial charge • Compute internal insurance cost • CVA per deal if advising • Optimizer risk/return via hedging • CVA sensitivities • Monitor and interact with ON CCR and CVA • Use baseline for risk monitoring • Trader compensation includes CVA charger • Use intraday updates for interacting • Monitor risk intraday.. Want portfolio effect (deal and at netting level).g. • May influence trade or counterparty Requirements • Calculate pre deal exposure and incremental CVA as amount for deal. on demand risk. or CVA -DVA • Calculate fair value of derivative portfolio 7 © 2012 IBM Corporation . whatifs • Run analysis with new trades and new scenarios • Comply with regulation (e.

…) and market variables – Correlations between market variables – Default probability and recovery value (often more art than science) – Netting (causes exposure to be reduced) – Collateral agreements (as above) – Wrong-way risk (credit derivatives in particular) © 2012 IBM Corporation . CVA of a swap involves volatility.g.Why is CVA so complex?  Calculating the CVA of a derivative is always more complex than pricing the derivative itself –  8 e. resets. exercises. but pricing the swap itself does not Must account for – Complexities of the trade (cash flows..

Algorithmics. December 2009 9 © 2012 IBM Corporation .Current practice: transition to active management Of the firms surveyed. 25% daily. 50% calculate CVA monthly. and 25% in real time Source: Credit Value Adjustment: and the changing environment for pricing and managing counterparty risk.

December 2009 10 © 2012 IBM Corporation . firms that cannot Source: Credit Value Adjustment: and the changing environment for pricing and managing counterparty risk. Algorithmics.Current practice: incremental CVA at deal time Pre credit crisis: firms that charged CVA were often at a pricing disadvantage relative to firms that did not Post credit crisis: firms that charge CVA on an incremental basis are a competitive advantage vs.

Algorithmics. or in a single risk group (17%).Survey : CVA – purpose and management of CVA  The main purpose of CVA today is to facilitate accounting reporting. followed by front office pricing: Source: Credit Value Adjustment: and the changing environment for pricing and managing counterparty risk. December 2009 11  In the front office. in multiple groups (25%). and 25% in real time © 2012 IBM Corporation .  50% calculate CVA monthly. 25% daily. CVA is owned by either a single front office unit (58%).

net/risk-magazine/feature/1594855/exposing-exposure 12 © 2012 IBM Corporation . we will be able to use our credit lines and capital more efficiently. netting and collateral “If we are able to measure our counterparty risk more accurately.”1 Source: 1)Risk Magazine. “Exposing counterparty risk exposure”. This will allow us to do more business with the same or lower limits.Pre-deal CVA: why use simulation approach? Simulation approaches enable risk reducing trades to be priced more competitively than risk increasing trades End-of-Day measure Option 1 Pre-deal analysis results Option 2 Option 3 Counterparty Portfolio Add-on measure Monte Carlo Standalone Monte Carlo Incremental 95% Peak Exposure $50M $2.risk.5M $1M ($2. March 2010. as our current conservative methodologies constrain the business and may overstate exposure. http://www. it lets us be sharper in our prices. And because we can understand the CVA in advance of doing a trade.5M) Unilateral CVA $100K $5K $2K ($5K) Highly conservative additive estimate of exposure and CVA Less conservative simulated approach to measure exposure and CVA Most accurate measure capturing diversification.

this is often wrong – Buying out of the money put options – Buying CDS protection – FX products with local currencies  Wrong way risk challenges 13 – Correlation and dependency are not the same thing – Wrong-way risk might be quite subtle / indirect – Wrong-way risk can be massive (mono-lines) © 2012 IBM Corporation .Wrong-way risk  It is typical to assume independence between – Default probability of counterparty – Exposure at default  But. in reality.

max = 10yrs – Market factors: short-rate calibrated to swaption vols – Credit modeling: no netting.A realistic example: why wrong-way risk matters (example 1)  Corporate Portfolio – 150 Swaps: one-directional (long fixed/short floating). all denominated in CAD – Maturities: min = 2wks. no collateral – Simulation time steps: quarterly to 10yrs (total of 40) 14 © 2012 IBM Corporation .

depending on right or wrong way risk 6.25 0.A realistic example: why wrong way risk matters (example 2) Corporate Portfolio CVA goes from $1.000 0 -1 -0.5 0.75 1 .000 1.000 4.000 2.000 15 © 2012 IBM Corporation 0.75 -0.7M .$5M.000 CVA depending on correlation “Wrong way” 5.000 “Right way” 3.25 0 -1.5 -0.

Portfolio credit risk framework 16 © 2012 IBM Corporation .

Wrong-way risk  Joint simulation of market and credit risk factors  Market. systemic & specific risk factors  Utilises existing economic capital models  Migrations and defaults modelled  Reduced number of micro/macro factors  Conditional scenarios  Enhanced performance 17 © 2012 IBM Corporation Market Factors Systemic Specific Credit Credit .

Credit exposure modeling: Monte Carlo simulation approach 18 1 MARKET RISK FACTOR SCENARIO GENERATION 2 POSITION VALUATION 3 AGGREGATION & NETTING 4 COLLATERAL ADJUSTMENT 5 OBTAIN EXPOSURE PROFILE FOR EACH SCENARIO 6 OBTAIN EXPOSURE METRICS © 2012 IBM Corporation .

CVA: Natural extension of credit exposure modeling MARKET RISK FACTOR SCENARIO GENERATION 1 CVA – Use Risk Neutral Scenarios 2 POSITION VALUATION 3 AGGREGATION & NETTING 4 COLLATERAL ADJUSTMENT 5 OBTAIN EXPOSURE PROFILE FOR EACH SCENARIO OBTAIN EXPOSURE METRICS 6 19 CVA .Calculate Discounted Expected Exposure © 2012 IBM Corporation .

Pre-trade/deal-time pricing of CVA New trade info F/O Product System Update portfolio Inception pricing CVA Engine CVA overrides Nonstandard queue Book trade View/adjust model inputs What-if trade What-if CVA Diagnostic GUI CVA What-if trade CVA CVA desk Marketer 20 © 2012 IBM Corporation CVA override .

and CVA  Model counterparty portfolio diversification. CSA parameters. netting.CVA desk: day in the life Pre-Deal  Calculate incremental impact of new trade on market and counterparty exposure. modeling assumptions End-of-Day  Measure market and counterparty exposures for limit and reporting purposes. as trades are booked  Investigate counterparty exposures  Ad-hoc stress tests on market factors. including VaR. use this information for pricing  Manage excesses Intra-day  Update market and credit exposure profiles to include impact of new trades. compare to limits  Calculate incremental impact of new trades on CVA. stress tests and counterparty PFE (shortfall above 90%). and collateral  Cover all trades including exotics  Calculate CVA across market scenarios to hedge P/L volatility  Manage excesses 21 © 2012 IBM Corporation .

Pro-active CVA management 22 © 2012 IBM Corporation .

proxies. market gaps • Overtrading due to unstable sensitivities Divergence between business practice and regulation (Basel III) DVA (Debt Value Adjustment) – Should you monetise your own default? – Link to funding Wrong-way risk – How to minimize wrong-way risk – How to create “right way” exposures Tight operational integration and fast analytics are both essential © 2012 IBM Corporation . liquidity.CVA desk: key challenges  Positioning of CVA desk – Centralised or decentralised – Profit centre or utility – Hedging policy –    23 • Basis.

CVA sensitivities  Credit  FX  Rates  Commodities  Equities  Volatility  Correlation  Cross gamma sensitivities  Full simulation approach  High performance computing 24 © 2012 IBM Corporation .

Real time architecture Credit Derivative Interest Rate Equity FX Trade Data Feeds 2 4 Control Desktop 1 Collateral Real Time Batch Analysis Trades Hierarchy Limits Scenario 2 Simulation 3 Aggregation & Limit Check 3 csv 4 Presentation Mkt Data Database Netting Calculation Engines Market Cpty Transient Intra Day Cache Real Time Scenario Builder Limits Report If using batch load Positions Exposure Historical Report Db Report Analysis 25 © 2012 IBM Corporation BI Tools .

5 hours Grid nodes 48 engines / 6 machines Computational time 113 CPU hrs Shortest simulation 7.Case study .5 hours) 97% of portfolio simulates in less than 30 minutes 26 © 2012 IBM Corporation .ENERGY All counterparties (PFE) 38% reduction Top 5 counterparties (PFE) 61% reduction 5 counterparties (PFE) 300% increase! CVA 33% reduction PERFORMANCE .17 seconds (~1.ENERGY End-of-day elapsed time 3.89 seconds Longest simulation 4631.energy RESULTS .

EQUITY All counterparties (PFE) 38% reduction Top 5 counterparties (PFE) 53% reduction CVA No model was used to calculate the value before Combined exposures simulated 10% of the counterparties shared PERFORMANCE .EQUITY 27 End-of-day elapsed time 2 hours Grid nodes 48 engines / 6 machines Computational time 18 CPU hours © 2012 IBM Corporation .Case study – equity derivatives RESULTS .

What are we seeing?  CVA is calculated in middle office/finance  CVA desks being established  Real time CVA pricing (sub second response time)  CVA sensitivities (over 100 sensitivities required)  Capital charge – affect on RWA’s  Liquidity/funding value adjustment 28 © 2012 IBM Corporation .

tight operational integration and fast and accurate analytics  CCR and CVA approaches need to be consistent and should leverage each other. Regulatory CVA is a separate stream. It needs to fit within a broader business vision.  CVA should be managed actively: CVA desk  Short cuts will not work: wrong way risk  “Best practice “ implementations are achievable – they are about both.Summary  CVA enables. requires a strategic change in risk culture and practice. in fact. 29 © 2012 IBM Corporation .