An Integrated OTC Derivatives Risk Capital Framework

Wujiang Lou and Gavin Xu1

1st Draft, September 2018; Updated October 2019

Abstract
Bilateral derivatives valuation is subject to counterparty credit risk (CCR) in that a
counterparty could jump to default or its credit spread could vary over time. In the
nomenclature of risk management, the former is called CCR exposure and the later leads
to credit valuation adjustment (CVA). As both depend on derivatives valuation, their
proper inclusion in risk management has been challenging and controversial. The CVA
capital charge, for example, has gone through a few formal implementations since its post
crisis inception, and is still subject to wide criticism. Furthermore, the reformed regulatory
risk capital framework does not address post-crisis advances in derivatives valuation
adjustments (xva). This article presents a holistic OTC derivatives risk capital framework
based on an integrated pricing model of market risk and counterparty credit risk. The new
framework pulls closer to real economic risk, reduces redundant capital requirements, and
cuts implementation costs.

Keywords: derivatives valuation, valuation adjustments (xva), counterparty credit risk

(CCR), credit valuation adjustment (CVA), CVA capital, economic capital.

1. Introduction

With the publication of “BASEL 3: Finalizing post-crisis reforms” in December

2017, the BASEL Committee on Banking Supervision (BCBS) has successfully concluded
almost decade long rule making effort. As the most impacted by the global financial crisis,
the banking industry has contributed to the regulatory response. Apart from undertaking

1
Wujiang Lou is with NYU, and Gavin Xu is with HSBC. The views and opinions expressed herein are the
views and opinions of the authors, and do not reflect those of their employers and any of their affiliates.

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large investments in implementing new BASEL 3 rules, it has also taken many initiatives
of their own. A prominent one has been a systemic update of OTC derivatives pricing and
valuation models. New value adjustments (so called XVAs) have emerged, including FVA
for funding, MVA for margin, colVA for collateral, LVA for liquidity, and KVA for capital.
Each XVA reflects an area insufficiently priced prior to the crisis. Not all XVAs are created
equal: some are more popular than others, but only CVA has attracted a dedicated risk
capital category in BASEL 3. FVA, for example, has been implemented by every major
bank since 2014, but it has not been mentioned in the finalized rules. A question awaiting
the Committee is when and how they would start the risk capital rule making effort for
FVA and other XVAs that already appear in the accounting fair value.
Such an effort will not be a light one, if only we look back at CVA’s entry path into
the regulatory capital framework. It was observed that, during the financial crisis, banks
suffered more CVA losses due to widening of counterparty credit spreads than direct
default loss. To take CVA volatility into account, the CVA risk capital charge (CVA capital
in short) was first introduced into BASEL 3 in December 2010, finalized in June 2011, and
went into effect in January 2013. Widely regarded as CVA VaR, it only considered
counterparty credit spread variations and left out exposure variations caused by market risk
factors. Two approaches were originally permitted, the standardized approach CVA and
internal model-based approach (IMA-CVA). Subsequently, the fundamental review of the
trading book (FRTB) makes substantial revisions to the 2011 CVA capital rule to form a
basic approach CVA (BA-CVA), and a standardized approach CVA (SA-CVA). SA-CVA
replaces the roughly-received original standardized approach. IMA-CVA is deemed too
complex and without a convergent implementation, and is removed against the wishes of
the industry (ISDA 2015).
CVA capital is not the only capital category applicable to OTC derivatives. In
BASEL I (1988), bilateral OTC derivatives’ capital treatment follows value-at-risk (VaR)
approach, as derivatives were priced without counterparty credit risk back then.
Counterparty credit risk (CCR) capital was introduced in 1995 as an amendment to BASEL
I to compute a capital add-on that reflects a bank’s derivatives exposure to counterparty
default. About the same time, the industry started to price in counterparty credit risk in the
credit valuation adjustment (CVA). In BASEL II (2005), more advanced exposure models

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for CCR, the standardized method and internal model method (IMM), were proposed in
addition to BASEL I’s current exposure method (CEM). With BASEL 3’s CVA addition,
a bilateral derivative transaction is subject to three silos of risk capital: VaR, CCR, and
CVA, representing respectively the primary market risk of the derivatives, default risk of
the counterparty, and market risk of the fair value adjustment due to CCR. As each is
computed on a standalone basis and has its own rules, methodology, system, and team, it
has been nearly impossible to maintain coherence of the risk capital framework and
truthfulness to the real economic risk (ISDA 2011).
The three silos of VaR, CCR and CVA for bilateral OTC derivatives’ risk capital
are rooted in the decomposition of the derivatives fair value V(t) into the default riskfree
value V*(t) and CVA, i.e., V(t) = V*(t) – CVA(t). Since late 1990’s, the default riskfree fair
value is computed at the trade level first, and CVA is computed separately at the netting
set level and gets allocated back to trades (Pykhtin and Zhu, 2007; Tang and Li, 2007).
Although a historical and logical evolvement of counterparty credit risk pricing, this
separation of counterparty credit risk from market risk is not ideal. One of the stated goals
for post-crisis reforms was an integrated market and credit risk capital framework (BCBS,
2009). In the FRTB (BCBS, 2013), this topic was revisited and the conclusion was that
there wasn’t a converging industry practice, to quote from BCBS (2013),

“The first consultative document discussed whether CVA should be captured in an

integrated fashion with other forms of market risk within the market risk framework
or continue to be calculated as a standalone capital charge. For the time being, the
Committee has decided that it is not appropriate for CVA to be fully integrated into
the market risk framework. The Committee believes that CVA must be treated
separately given the complexity and model risk in an integrated model and that
allowing full integration may lead to significant variation in results.”

While the committee chose to settle the CVA rules at FRTB’s SA-CVA, somewhat
as a compromised goal, criticism levied against CVA has recently intensified. Over the
years, the industry has built very sophisticated, often burdensome, and high cost CVA
implementations. Meanwhile, academics remain skeptical of the fitness of such

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implementations, because of no observability of key input parameters such as the recovery
rates and correlation (Wood, 2017). Another criticism is the wide use of credit spread
proxies in an environment of declining credit default swaps (CDS) trading (Brigo, 2018).
To overcome excessive computational complexity and costs, many implementation short
cuts are taken. Consequently, significant variation in results in CVA and CVA capital
exists. Recognizing these difficulties, the Committee decides to drop the IMA-CVA from
its final proposal (BCBS, 2017), in spite of banks’ argument that the IMV-CVA would
have allowed them to manage CVA risk more efficiently (ISDA, 2015). The new wave of
criticism on CVA and dissatisfaction with the new standard may be unsettling to the
finalized rules.
This paper sets out to study the conceptual feasibility of integrating counterparty
risk capital with the market risk framework. This would only result from an integrated
market and credit risk pricing model. Utilizing the liability-side pricing (LSP) theory (Lou
2015, 2016), the fair value is obtained as the liability-side counterparty’s senior unsecured
financing rate discounted cash flows. The model goes straight at the final fair value and
calculation of CVA is not necessary, as the model value already takes into account of
counterparty credit risk alongside with primary market risk factors. By feeding the model
with joint scenarios of market risk factors and counterparty credit spreads, market risk
measures obtained such as VaR or expected shortfall (ES) automatically cover CVA’s
variability due to counterparty credit spread and counterparty exposure as well. Thus the
need for CVA capital is eliminated.
An integrated derivatives pricing model is inherently consistent with corporate
bond pricing. That is to say, the valuation adjustments the model implies, when added back
to the riskfree bond price, will reproduce current bond market price. OTC derivatives
would be discounted in the same manner as other trading book exposures to a counterparty,
e.g., debts issued by the same issuer. To align OTC derivatives with trading book debt
instruments from a risk capital perspective, an experiment is made to remove CCR and to
extend the default risk charge (DRC) from its current scope of corporate debts and equity
instruments to OTC derivatives. Numerical examples at the hedging set and netting set
levels are provided to illustrate possible impacts.

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2. OTC Derivatives Capital Treatment in BASEL 3

At a high level, a bilateral derivative transaction is subject to three separate yet

additive risk capital requirements: VaR, CCR, and CVA, each representing the market risk
of the default free price, default risk of the counterparty, and market risk of CVA or CVA
VaR.
Consider a bond in a trading book. In one period [t0, t1], three scenarios could
happen as shown in Figure 1: 1.) no default and no rating change, new price V1 at t1. 2.)
new credit rating, new price V1, likely a large deviation from V0. 3) default in the period,
with a fractional recovery R at t1.

Bond OTC
3. Default IRC CCR

2. NewRating IRC N/A

t0, V 0 1. t1, V 1 VaR VaR+CVA

Figure 1. One step diagram illustrating BASEL 3’s risk capital design for a trading book
bond position as compared with OTC derivatives.

BASEL 3’s treatment in each scenario is listed in the embedded table of Figure 1
under the heading of ‘Bond’. Briefly, general VaR (and stress VaR 2 ) handles case 1.
Incremental risk charge (IRC) is for default and rating migration risk of single issuer debts
with a confidence interval of 99.9% in one year horizon. Because it takes a credit portfolio
approach (i.e., with correlation effect), it requires a standalone implementation, separate of
the standard VaR system. The main challenge has been the specification of the default (and

2
Stress VaR is introduced in BASEL 2.5 in 2009, which is separately computed based on a historical stress
period and added to the regular VaR based on the recent market period. This apparent overlay of a stress
period over a recent period could be understood as a first response to the financial crisis, but it obviously
deviates from the traditional definition of economic risk capital as a loss reserve covering a stated investment
horizon.

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rating migration) correlation, rarely observable in the market and hard to robustly estimate
with limited historical default data. Although a few theoretical correlation models are
possible, there has been a lack of published standard IRC implementation. As a result,
methodologies vary largely among dealer banks.
BASEL 3’s treatment for bilateral OTC derivatives is listed in the column with the
heading of ‘OTC’. Noticeably, both VaR and CVA risk capital work under case 1 and CCR
plays the same role for OTC derivatives as IRC for trading book bond positions.
In FRTB, credit rating migration has not been viewed positively and is dropped.
Figure 2 shows the remaining cases: no default, new price at t1; default in the period with
a fractional recovery at t1. Default risk charge (DRC) takes the place of IRC and ES
(expected shortfall) replaces VaR. Current DRC scope includes bonds and equities in the
trading book, taking into account of default correlation. From an implementation point of
view, this is much simpler as there is no more need of modeling rating migration. For OTC,
both CCR and CVA stay, although the standardized approaches have all been changed from
earlier version of BASEL 3.

Bond OTC
3. Default DRC CCR

t0, V 0 1. t1, V 1 ES ES+CVA

Figure 2. One step diagram illustrating FRTB’s risk capital framework design of trading
book bond and OTC derivatives.

Heuristically, separating counterparty credit spread risk from other risk types that
contribute to the exposure leads one to write cva = ead * cpd, where ead is the derivatives
exposure, cpd counterparty’s probability of default. Then by product rule, 𝑑(𝑐𝑣𝑎) =
𝑑(𝑒𝑎𝑑) ∗ 𝑐𝑝𝑑 + 𝑒𝑎𝑑 ∗ 𝑑(𝑐𝑝𝑑). The first issue with this type of approximation is that it
works in differential form, meaning small changes, but risk capital deals with tail behavior,
not usually a small change. The second issue is, on a forward time basis, both ead and cpd

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are stochastic, and there is a covariance term (assuming diffusion) of d(ead)*d(cpd), which
is exactly the wrong way risk. Particularly for counterparty credit risk, this has offsetting
effect which can be naturally recognized by integrated pricing of counterparty credit risk
and market risk.
After the publication of FRTB’s standardized approach to trading book market risk
(SA-TB), the Committee adopts the same sensitivities driven approach to CVA to produce
the standardized approach for CVA (SA-CVA). SV-CVA is the aggregation of delta and
vega risks. The capital requirements for delta and vega risks are calculated for the entire
CVA book (all trades with counterparty risk plus eligible hedges). The delta risk capital is
independently calculated under six risk types: interest rate, foreign exchange, reference
credit spreads, equity, commodity, and counterparty credit spreads. The vega risk capital
is the same except for the exclusion of the last risk type. Gamma sensitivity is dropped to
reduce computation complexity. This is a significant improvement over earlier Basel 3
CVA capital, but the pitfalls of separating from market risk remains.

3. Integrated Market and Counterparty Credit Risk Valuation

In the liability-side pricing (LSP) theory (Lou 2015, 2016), the risk neutral pricing
formula for a European style derivative is extended as follows,

𝑇
𝑉(𝑡) = 𝐸𝑡𝑄 [𝑒 − ∫𝑡 𝑟𝑒 (𝑢)𝑑𝑢
𝐻(𝑇)] (1)
𝑟𝑒 (𝑡) = 𝑟𝑏 (𝑡)𝐼(𝑉(𝑡) ≤ 0) + 𝑟𝑐 (𝑡)𝐼(𝑉(𝑡) > 0) (2)
where H(T) is a T-filtration measureable random variable representing the derivative’s
payoff, rb(t) and rc(t) are the short rate processes for counterparties B and C’s senior
unsecured debts, I(. ) is the indicator function.
In general, equation (1) is coupled or recursive, as the risky discount factor
𝑇
𝐷(𝑡, 𝑇) = 𝑒 − ∫𝑡 𝑟𝑒 (𝑢)𝑑𝑢
depends on the local fair value. A bilateral derivative’s no-arbitrage
price is the expected risky discount of the derivative payoff under the risk neutral measure
Q. Here market risk is captured through usual risk-neutral primary asset dynamics under

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Q-measure, while counterparty credit risk represented by rb(t) and rc(t) is incorporated
through the discount rate, and together they produce the fair value in equation (1).
One price thus takes into account both market risk and counterparty risk. No
adjustment, CVA or FVA, is necessary. Nonetheless, a total counterparty risk adjustment
(CRA) can be precisely defined, if desired. CRA is trivially the difference of V(t) and the
(counterparty) risk-free value V*(t). Let U(t) = CRA= V*(t) - V(t), and we have UT=0,
because V(T)* = V(T) = H(T). The counterparty default riskfree fair value is given under
the same Q-measure by

𝑇
𝑉 ∗ (𝑡) = 𝐸𝑡𝑄 [𝑒 − ∫𝑡 𝑟(𝑢)𝑑𝑢
𝐻(𝑇)] (3)

where r(t) is the adapted short rate process for cash deposit or bank accounts. The CRA
formula is exactly,

𝑇 𝑠
𝑈(𝑡) = 𝐸𝑡𝑄 [∫𝑡 (𝑟𝑒 (𝑠) − 𝑟(𝑠))𝑉 ∗ (𝑠)𝑒 − ∫𝑡 𝑟𝑒(𝑢)𝑑𝑢 𝑑𝑠 ] (4)

Intuitively, the total adjustment made to the risk-free price is the sum of liability
side discounted excess return (re-r) on a notional amount of V*(t).
This form of liability-side discounting and pricing can be easily extended to apply
to a netting set. Equation (1) for example can be written to include a stochastic integral
involving a dividend process. If the netting set has cash collateral, then the above equation
can be modified as follows,

𝑟𝑒 (𝑡) = 𝜇(𝑡)𝑟(𝑡) + (1 − 𝜇(𝑡))[𝑟𝑏 (𝑡)𝐼(𝑊(𝑡) ≤ 0) + 𝑟𝑐 (𝑡)𝐼(𝑊(𝑡) > 0)] (5)

𝑇 𝑠
𝑈(𝑡) = 𝐸𝑡𝑄 [∫𝑡 (𝑟𝑒 (𝑠) − 𝑟(𝑠))(𝑉 ∗ (𝑠) − 𝐿(𝑠))𝑒 − ∫𝑡 𝑟𝑒(𝑢)𝑑𝑢 𝑑𝑠 ] (6)

𝐿𝑡
where 𝜇𝑡 is the portion of V(t) being cash collateralized, i.e., 𝜇𝑡 = ⁄𝑉 , L(t) is the cash
𝑡

collateral amount posted, and W(t)=V(t)-L(t) is the unsecured amount. Strictly speaking,

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these quantities are adapted processes in a properly defined and filtered probability space,
with filtration sufficiently enlarged to include the counterparty’s credit and funding rates.
In the special case where the hedging set or a netting set is an asset at all times, the
discount rate is simply the counterparty’s senior unsecured rate, same rate used to discount
a corporate bond. This form of pricing therefore accomplishes consistency between
bilateral defaultable derivatives pricing and defaultable bond pricing. An added benefit is
the avoidance of the recovery rate 3 , an input not without controversies in terms of its
observability and random nature as discussed in Brigo (2018) and Wood (2017).
This scheme of discounting and pricing can be shown in the familiar partial
differential equation (PDE) form. For a single underlying risk factor hedging set, e.g., a
stock, the Black-Scholes-Merton PDE is

𝜕𝑉 𝜕𝑉 1 𝜕2 𝑉
+ (𝑟𝑠 − 𝑞)𝑆 𝜕𝑆 + 2 𝜎 2 𝑆 2 𝜕𝑆2 − 𝑟𝑒 𝑉 = 0 (7)
𝜕𝑡

Subtracting the BSM equation for V* from the extended PDE leads to,

𝜕𝑈 𝜕𝑈 1 𝜕2 𝑈
+ (𝑟𝑠 − 𝑞)𝑆 + 𝜎 2𝑆 2 − 𝑟𝑒 𝑈 − (𝑟𝑒 − 𝑟)𝑉 ∗ = 0 (8)
𝜕𝑡 𝜕𝑆 2 𝜕𝑆 2

Noting UT=0, application of Feynman-Kac theorem immediately leads to the CRA

formula (4).
This CRA represents total valuation adjustment made to take into account of
unsecured counterparty exposure, in both credit and funding aspects. Following Lou (2015)
where CRA for a fully uncollateralized OTC derivatives trade is decomposed into credit
valuation adjustment (cva4), debt valuation adjustment (dva), credit funding adjustment
(cfa), and debt funding adjustment (dfa), equation (8) can be subsequently split into four
components, U(t) = cva(t) - dva(t) + cfa(t) - dfa(t),

3
A corporate bond is priced and quoted in yield or credit spread without any reference to a recovery rate. A
credit default swap (CDS) is quoted either with an explicit recovery rate or with an implicitly market
assumption of the recovery rate, typically 40%. Moody’s historical default study shows that the median
recovery value is close to 40%, but a very large dispersion exists.
4
We use lower case acronyms as their definitions are different from conventional CVA and FVA. The key
is that only CRA is precisely and unambiguously defined.

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 𝑇 𝑠
𝑐𝑣𝑎(𝑡) = 𝐸𝑡𝑄 [∫𝑡 𝑠𝑐 𝐼{𝑉(𝑠) > 0}(𝑉 ∗ (𝑠) − 𝐿(𝑠))𝑒 − ∫𝑡 𝑟𝑤 𝑑𝑢 𝑑𝑠 ], (9.a)

𝑇 𝑠
𝑑𝑣𝑎(𝑡) = −𝐸𝑡𝑄 [∫𝑡 𝑠𝑏 𝐼{𝑉(𝑠) ≤ 0}(𝑉 ∗ (𝑠) − 𝐿(𝑠))𝑒 − ∫𝑡 𝑟𝑤 𝑑𝑢 𝑑𝑠 ], (9.b)

𝑇 𝑠
𝑐𝑓𝑎(𝑡) = 𝐸𝑡𝑄 [∫𝑡 𝜇𝑐 𝐼{𝑉(𝑠) > 0}(𝑉 ∗ (𝑠) − 𝐿(𝑠))𝑒 − ∫𝑡 𝑟𝑤 𝑑𝑢 𝑑𝑠 ], (9.c)

𝑇 𝑠
𝑑𝑓𝑎(𝑡) = −𝐸𝑡𝑄 [∫𝑡 𝜇𝑏 𝐼{𝑉(𝑠) ≤ 0}(𝑉 ∗ (𝑠) − 𝐿(𝑠))𝑒 − ∫𝑡 𝑟𝑤 𝑑𝑢 𝑑𝑠 ]. (9.d)

These formulae are based on the decomposition of the credit spread. Party B’s
credit spread with respect to the OIS rate, for example, is decomposed into a credit
component sb that associates to B’s CDS premium, and a (funding) basis component µb
that reflects B’s bond and CDS basis. By definition, rb - r = sb + µb and rc - r = sc + µc, this
scheme avoids any overlapping among these xvas.
Such a decomposition conforms to the law of one price, an issue central at the FVA
debate (Hull and White, 2012), as party B’s cva (cfa) is exactly C’s dva (dfa). In particular,
fva refers to the liability-side’s funding basis, in parallel with cva which refers to its default
risk premium. Equations (9a, b, c, d) are essentially solutions to a backward stochastic
differential equations (BSDE). In general, it is non-trivial to solve, as it involves coupled
forward price of the derivatives and its applicable discount rate at time s, s>t. In a Monte
Carlo simulation based of the whole netting set, equations (1, 4, and 9) can be easily
extended to cope with different products and cash flows. The effective discount rate can be
decoupled when computing backward in time, similar to the LSP binomial tree model (Lou,
2017).
The main advantage of formula (3 & 4) is that the primary risk factor is incorporated
in the Q-measure while the adapted counterparty credit risk factor is incorporated naturally
through the (path-wise) discount factor. Therefore, market risk and counterparty credit risk
is integrated, achieving BASEL’s original goal (BCBS, 2009) from the pricing perspective.
Although ISDA’s netting set covers all derivatives transactions between the two
parties unless explicitly excluded, its comprehensive netting effect is seldom enforced in a
one-cut manner. The close-out valuation of a netting set depends on a valuation process
centered at dealer-poll. There has been very few dealer-banks who could bid a portfolio of

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mixed risk types, e.g., a portfolio of interest rate derivatives and credit derivatives.
Accordingly, bankruptcy courts have allowed different subsets of a legal binding netting
set to be sold separately on significantly different dates. A rigid netting set enforcement in
CVA calculation that has all positions get cleared on the same settlement date, therefore,
is too idealistic. Practically, a defaulting firm’s derivatives portfolio will have to be split
into smaller subsets and sold separately to different parties5. A more realistic yet prudent
valuation and risk management approach is to follow risk factors or hedging sets that group
trades of the same primary market risk factor into a subset.

4. New OTC Risk Capital Framework

In our proposal, CVA capital is captured in VaR (or ES): CVA capital accounts for
CVA variability due to counterparty spread changes (early BASEL 3) and exposure change
due to market risk factors (BASEL after FRTB). With the liability-side pricing model,
CVA is already contained in the full price that comes out of the model directly. When the
counterparty credit spread is simulated along with market risk factors, VaR has contained
CVA variability and its contribution to the potential loss. Therefore, there is no need to
separately compute CVA capital.
In the current BASEL 3 and FRTB CVA risk capital framework (BCBS, 2017), a
bank’s own default is not considered when computing the regulatory CVA. Since existing
accounting CVA is computed based on an exposure model, this is commonly taken as to
ignore the negative exposure, which would result in a benefit upon the bank’s own default,
i.e., debt valuation adjustment (DVA). To satisfy BASEL 3’s requirement that the
regulatory CVA should not involve the bank’s own default, we can set rb = r, i.e., both sb
=0 and µb =0, and use the same fair value model. This is in the spirit of BASEL’s
requirement of ignoring self-default, although the exact numerical form is slightly different
from the current CVA definition.

5
For example, Citi settled its derivative valuation dispute with Lehman Brothers (Scurria, 2017) nearly ten
years after Lehman Brothers’ default in 2008. And Credit Suisse resolved its dispute in June, 2018
(Fitzgerald, 2018) with only a fractional recovery of its valuation claim.

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 Bond OTC
2. Default DRC DRC+

t0, V 0 1. t1, V 1 ES ES+

Figure 3. One step diagram illustrating proposed risk capital framework design of trading
book bond and OTC derivatives.

Note that BASEL never explicitly states the term “credit spread” to mean credit
default swap spread. Although its discussion of the CVA computation refers to default
probabilities and loss-given-defaults, commonly associated with CDS rather than cash
bond, it nevertheless accepts default probabilities inferred from bond credit spread, at least
when an issuer has no CDS. CDS has become much less liquid following the financial
crisis. Such is the case, CVA as a credit risk measure should be understood to have a
synthetic (i.e., CDS) form and a cash (i.e., bond) form. In the cash form, it is the same as
our CRA, which includes FVA due to the bond and CDS basis risk. Thus our version of
integrated VaR covers both CVA and FVA.
Furthermore, DRC can be expanded to account for CCR. A one period DRC model
could conceptually take the following steps:
1) Simulate defaults: calculate the default barrier for each name using its credit spread,
simulate multi-name asset returns, and determine which names default by comparing
a name’s asset return to its default barrier;
2) Calculate default loss: for names in default, determine losses by applying LGD to
period start exposures; with constant positions, revaluate credit exposures (bonds,
CDS, on shortened maturity with new credit spreads.), or with constant risk, compute
gain/loss by applying exposures’ CS01 (credit spread delta) to spread changes since
the period start;
3) Reset default barrier for next period: for names not in default, determine new credit
spreads corresponding to the simulated period end asset returns; for defaulted
names, assume they are replaced with other counterparties with the equivalent
creditworthiness, i.e. set the credit spreads to the initial values

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 The one year DRC horizon can be cut into multiple periods, e.g., one month per
period, see Figure 4. To apply DRC to OTC derivatives, we need to calculate the portfolio
mtm at starting point of each period. For this purpose, we assume constant risk. To begin
with, 𝑚𝑡𝑚0 which is the initial portfolio value is known. 𝑚𝑡𝑚𝑖 = 𝑚𝑡𝑚𝑖−1 + Δ ⋅ 𝜖 where
Δ is the constant risks and 𝜖 the risk factor vector. Loss in 𝑖𝑡ℎ period is 𝐿𝐺𝐷 ⋅ 𝑚𝑡𝑚𝑖−1.
Total DRC loss over 1 year is the sum of the losses in all periods.
Alternative way is to assume constant position, which would require knowledge of
forward underlying levels, e.g., stock price for options, forward swap rate for swaptions,
which can only be done via Monte Carlo simulation. This is equivalent to the IMM method
for CCR risk under Basel. It is extremely costly and difficult to do it accurately or even
correctly given the dimension of the problem. In theory, a local simulation can be made to
value derivatives forward prices. Many banks run a very limited number of paths, e.g.,
1000. It is unrealistic to expect a derivatives portfolio’s forward value distribution can be
computed with reasonable and consistent accuracy. Since we choose to approximate rather
than revaluate V1, V2 etc., there is no need for forward exposure model such as SA-CCR.
The alternative of computing or simulating forward exposure

2. Default Default

t0, V 0 1. t1, V 1 t2, V 2

Figure 4. Multi-step diagram illustrating proposed DRC extension for OTC derivatives.

Our main motivation is to better capture economic risks as reflected in the post-
crisis research advances in pricing and valuation of OTC derivatives under collateralization,
margining, and funding constraints. A number of issues concerning CVA practice prior to
the crisis have been raised (Wood 2017, Brigo 2018), including the proper close-out rule
to use, the effect of a netting set, and unobservable recovery rates and other inputs. To
some extent, a new wave of revisiting CVA has arrived. The proposed risk framework
aligns CVA in totality with FRTB SA-TB treatment, eliminating existing differences of

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the SA-CVA from the SA-TB, including reduced granularity of market risk factors, use of
more conservative risk aggregation; and use of multiplier CVA m. The new capital
framework does not require CVA6.
A second motivation is to answer questions as what to do about risk capital
treatment of FVA (funding valuation adjustment). As FVA becomes a part of the banks’
accounting fair value and the regulators’ desire to align regulatory valuation with
accounting valuation, it would be logical to charge a risk capital for variation of FVA due
to either the funding curve used or the market risk factors that contribute to the exposure.
This topic has not been openly discussed, however, because FVA still has its own
controversies. Hull and White (2012) find that FVA cost overlaps with DVA and that only
the basis component of FVA is admissible. Anderson, Duffie and Song (2018) determine
that FVA should not be part of the fair value.
The version of FVA proposed in Lou (2015 and 2016) is different from the above.
Essentially it is complimentary to CVA with the funding (or liquidity) basis risk. In other
word, it transforms the synthetic form of CVA to its cash form. There is no such a need to
introduce separately a capital for FVA, so long as we use counterparty’s senior unsecured
bond yield curves instead of CDS curves.
Other XVAs are also possible as LSP can potentially price them into the fair value
without making explicit and separate adjustments (Lou 2017). This proposal could save the
industry significant CVA/CCR implementation costs, human or non-human, and
strengthen the regulatory capital framework on a more solid technical base.

5. VaR and CVA Capital Results

Consider a hedging set (within a netting set between parties B and C) that is a
portfolio of forward, equity swap, and options on one underlying stock. The only primary
risk factor is the stock price St governed by a Brownian motion,

𝑑𝑆(𝑡) = 𝑟𝑠 𝑆(𝑡)𝑑𝑡 + 𝜎𝑆(𝑡)𝑑𝑊(𝑡) (10)

6
Indeed, one might ask, why keep CVA at all, since the fair value calculated has already integrated
counterparty credit risk? Answers to this depend on how CVA risk is hedged and managed.

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 For simplicity, we assume that the parties’ financing rates under the Q-measure are
governed by the same common factor x(t), an Ornstein-Uhlenbeck (OU) process as follows,

𝑑𝑥(𝑡) = −𝑘𝑥(𝑡)𝑑𝑡 + 𝜈𝑑𝑍(𝑡) (11.a)

𝑟𝑏 (𝑡) = 𝑟(𝑡) + 𝜇𝑏 (𝑡) + ℎ0𝑏 𝑒 𝛼𝑏 𝑥(𝑡) (11.b)
𝑟𝑐 (𝑡) = 𝑟(𝑡) + 𝜇𝑐 (𝑡) + ℎ0𝑐 𝑒 𝛼𝑐𝑥(𝑡) (11.c)

where r(t), 𝜇𝑏 (𝑡), 𝜇𝑐 (𝑡) are deterministic, ℎ0𝑏 , ℎ0𝑐 , 𝛼𝑏 and 𝛼𝑐 are constants representing the
initial default hazard rates and loadings on the common factor x(t) with initial condition
x(0) = 0. These parameters allow calibration of the model to B and C’s bond yield curves.
The two Brownian motions are correlated, < 𝑑𝑊(𝑡), 𝑑𝑍(𝑡) > = ρdt. ρ is the correlation
coefficient. For BASEL 3 risk capital purposes, the bank’s own default risk is excluded.
Simply set 𝜇𝑏 (𝑡) = 0 and ℎ0𝑏 = 0, so that rb(t)=r(t), leaving out rc(t) modelled as is.
In such a joint model, the valuation of the hedging set (once solved numerically)
naturally incorporates both the stock price risk and the counterparty credit risk. Equations
(1&2) are still valid, and can be solved via a Monte Carlo simulation. Given the particular
form of single factor credit spread processes, a 2-dimentional Black-Scholes-Merton style
PDE similar to (7) can be derived and solved with 2-D finite difference scheme for a
portfolio of derivatives on the same underlying stock. To illustrate, we start with an
uncollateralized shifted equity forward contract composed of a long call at 55 strike and a
short put at 45 strike with a spot price at 50.

Table 1. Fair value of long/short shifted equity forward. σ =50%, r=5%, repo spread 1.5%,
ρ =-50%, k=1, vol of spread 𝜈 =100%. 𝜇𝑏 =0.3%, 𝜇𝑐 =0.8%, ℎ0𝑏 =1%, ℎ0𝑐 =2.5%,
𝛼𝑏 =0.5, 𝛼𝑐 =0.8.
V V* cva dva cfa dfa xva
long fwd 3.4855 3.6334 0.1465 -0.045 0.0577 -0.011 0.1479
short fwd -3.7087 -3.6334 0.1307 -0.0626 0.0289 -0.0218 0.0753

Table 1 shows the all-in fair values of a long forward position and a short forward,
along with the default risk free value, total xva and its decomposition into cva, dva, cfa,
and dfa. Noticeably the long and short fair values are different, because the parties have
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different credit spreads, unlike the default risk free price which is indifferent to position
sides. All these quantities are solved from the same FD scheme simultaneously.
With an FD model in place, we can proceed to compute sensitivities of the fair
value per SA-CVA described in BCBS (2017). The sensitivities are computed by shifting
the equity price, equity volatility and counterparty credit spread by 1%, 1%, and 1 bp
respectively, shown in the first three columns of Table 2 as delta, vega, and CCR delta.
The first row (‘Full LSP’) shows results with both counterparty’s credit risk considered,
while the second row (‘GoingConcern’) shows the bank as a going-concern by setting its
discount rate to the OIS in the LSP model. SA-CVA are shown with equity and
counterparty credit risk types, 1.0906 and 0.3602 respectively with full LSP pricing, not
much difference from going-concern pricing.

Table 2. Comparison of Sensitivities and SA-CVA capital of a long shifted forward.

Sensitivities SA-CVA
delta vega CCR delta Equity Cpty-CR
Full LSP 0.9102 0.1876 5.7635 1.0906 0.3602
GoingConcern 0.91 0.1878 5.7673 1.0935 0.3605

To compute the (daily) stress VaR, we use the 2-year daily return history of the
SPX financial index over a stress period of June 2007 to June 2009, and the historical daily
change of the 5 year CDS spread of a large mega-bank over the same stress period as a
proxy for party B -- a hypothetic bank, and party C – a financial client. Under the full LSP,
the stress VaR of the standalone long forward position is 0.3852, comparing with the stress
VaR of the default risk free pricing at 0.468. The full LSP VaR is about 18% less.
Excluding CCR for now, capital requirement for this standalone shifted equity
forward is 0.3852 under the proposed framework, about 10% of the fair value. Under
BASEL 3 with FRTB, it will be 1.9188, sum of Var (V*) and SA-CVA, 5 times as much.
Although an extremely simple example, the possibility of large excess of risk capital under
the FRTB CVA framework is clearly revealed.
Now expanding the hedging set to a randomly generated European options portfolio
with option moneyness evenly distributed around 80% and 120%, expiries from 0.5 to 2
years, and equally likely call or put. We select three portfolios such that their long positions

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are about 20%, 50%, and 80% out of 100 total positions. Table 3 shows the fair value of
these portfolios, computed VaR, SA-CVA, and risk capital excluding CCR in the last two
columns.

Table 3. Comparison of risk capital calculations for three hedging sets with different
exposure profiles.
Corr Long(%) V V* V-VaR V*-VaR SA-CVA BASEL 3 Integrated
-0.5 50 -74.36 -74.94 23.4 23.7 2.9 26.6 23.4
-0.5 80 496.05 518.55 20.0 19.2 71.3 90.5 20.0
-0.5 20 -775.37 -787.20 80.1 80.5 0.0 80.5 80.1
0.5 50 -73.87 -74.94 23.4 23.7 2.4 26.1 23.4
0.5 80 494.14 518.55 19.0 19.2 85.5 104.7 19.0
0.5 20 -774.45 -787.20 79.7 80.5 0.0 80.5 79.7

The only portfolio showing significantly less capital is the 80%-long portfolio that
has a current riskfree MTM of 518.55, a large positive exposure to party C. With negative
correlation at 50%, the integrated capital is 207, only 22% of Basel 3 capital at 90.5. The
mildly negative exposure portfolio with 50%-long is about 10% less. The 20%-long
portfolio does not have counterparty exposure, so its SA-CVA is zero, and VaR close to
the riskfree VaR.
As discussed earlier, the integrated approach models wrong way risk directly. When
the equity and credit correlation flips from negative 0.5 to positive 0.5, risk capital under
the integrated approach is rather stable, changing only from 20.0 to 19.0 with the 80%-long
portfolio. SA-CVA however shows a large change, from 71.3 to 85.5. This is contributed
to the segregated treatment of equity risk type and counterparty credit spread risk type,
each accounted for 30.6 and 40.7. It is clear that when the bank has a large exposure to its
counterparties, the integrated approach will yield much less capital.
In the VaR calculation above, we have fixed the volatility at the pricing vol of 50%.
To consider historical volatility, we added a two year put option with strike of 50 such that
each portfolio is not vega neutral. Results are shown in Table 4. Comparing to the case of
constant vol scenario, exposures in all three portfolios are smaller. Yet CVA sensitivities

7
We’re only showing 99% daily VaR here. The 97.5% ES number is 20.78.

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are greater, resulting in larger SA-CVA capital. Overall, the integrated capital now
accounts 60% to 70% of the Basel 3 capital, see the last column of Table 4.

Table 4. Comparison of risk capital calculations for three vega neutral hedging sets with
different exposure profiles.
Corr Long(%) V V* V-VaR V*-VaR SA-CVA BASEL 3 Integrated%
-0.5 50 -18.26 -15.05 34.6 34.0 16.3 50.3 68.9%
-0.5 80 109.26 109.79 91.7 96.3 44.1 140.4 65.3%
-0.5 20 -188.10 -164.01 193.8 187.8 110.3 298.1 65.0%
0.5 50 -16.79 -15.05 34.1 34.0 14.4 48.4 70.4%
0.5 80 103.91 109.79 92.0 96.3 58.7 155.0 59.3%
0.5 20 -178.07 -164.01 189.8 187.8 98.0 285.9 66.4%

6. CCR and DRC Comparison with Multiple Netting Sets

To demonstrate the benefits of the integrated risk capital framework at the book
level, we consider a hypothetical trading book consisting of 5 swap portfolios. Each
portfolio is constituted of 100 fix-float interest rate swaps with randomly generated
maturities (up to 10 years) and equal notional of 100. To simulate interest rate, an adapted
Hull-White model was used. A Black-Karasinski model was used to capture the bond curve
for risky discounting:
𝑑𝑙𝑛(𝜆𝑡 ) = 𝛼𝜆 (𝜃𝜆 − ln(𝜆𝑡 ))𝑑𝑡 + 𝜎𝜆 𝑑𝑊𝑡 (12)
To facilitate analysis of model behaviors below, we assume all counterparties have the
same creditworthiness. However, correlations between the counterparties are randomly
chosen.
The difference between the risk-free price and LSP price is CRA. Here CRA =
CVA-DVA, as zero bond-CDS basis is assumed. As shown in Figure 5, CVA-DVA
increases with the moneyness because the positive exposure increases and CVA dominates
DVA. Note that the moneyness is calculated using the risk-free discounting method. In the
deep out-of-money case, CVA is less than DVA and the price difference reflects the DVA
benefit.

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 CRA=CVA-DVA
30.00

25.00

20.00

15.00

10.00

5.00

-
0.70 0.80 0.90 1.00 1.10 1.20 1.30
(5.00)

(10.00)

(15.00)

Figure 5. Liability Side Pricing Implied CVA-DVA vs Portfolio Moneyness where 𝝀𝟎 =

𝟎. 𝟎𝟏𝟐, 𝜶𝝀 = 𝟎. 𝟎𝟓, 𝜽𝝀 = 𝒍𝒏(𝟎. 𝟎𝟏𝟓) , 𝝈𝝀 = 𝟏𝟎𝟎% for all counterparties.

CRA=CVA-DVA
70.00

60.00

50.00

40.00
CRA

30.00

20.00

10.00

-
(0.90) (0.60) (0.30) (0.00) 0.30 0.60
(10.00)

Figure 6. Wrong Risk Implied in LSP where 𝝀𝟎 = 𝟎. 𝟎𝟏𝟐 , 𝜶𝝀 = 𝟎. 𝟎𝟓, 𝜽𝝀 =

𝒍𝒏(𝟎. 𝟎𝟏𝟓) , 𝝈𝝀 = 𝟏𝟎𝟎% for all counterparties.

In the liability-side pricing model, correlation between counterparty default and

exposure is directly captured. As illustrated in Figure 6, as correlation increases, CRA also
increases due to rising wrong way risk.

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 As discussed earlier, there is no more need to calculate a separate CVA VaR (i.e.
CVA capital) because this is already embedded in VaR with the liability-side pricing
model. Since the spread risk component of the entire counterparty credit risk is explicitly
priced in and also accounted for in VaR, the only residual risk is the gap risk due to jump
to default, which is taken into account of the enhanced DRC model discussed in Section 4.
To understand the impact, we calculate capital charges with BASEL/FRTB. VaR
was chosen to be 99% of the PnL loss. To simplify the computation, the PnLs are simulated
directly from the underlying Hull-White and Black-Karasinski models. For DRC, the one
year horizon has a liquidity zone set to be 1 month. A 2-factor Gaussian copula model is
used to simulate defaults with randomly generated loading. The bond spread is jointly
simulated with the default with a negative correlation (i.e. when a name is more likely to
default, the Gaussian latent variable goes more negative and in the meantime the credit
spread widens). The correlation can’t be perfect due to jump to default risk. In our test, we
set it to be -0.6. Counterparty credit spread is assumed to have 200 bps initial value with
lognormal volatility of 150%.
Since a typical bank’s trading book is market risk hedged to a large extent, we
assume the trading book consists of 2 portfolios with aggregated notional 110mm and -
100mm. In another words, the net exposure is about -10mm.

Table 5. Comparison of the proposed risk capital calculation to BASEL 3. 𝝀𝟎 = 𝟎. 𝟎𝟐,

𝜶𝝀 = 𝟎. 𝟎𝟓, 𝜽𝝀 = 𝒍𝒏(𝟎. 𝟎𝟏𝟓) , 𝝈𝝀 = 𝟏𝟓𝟎% for all counterparties.

Correlation = 0 Correlation = -0.25

High CS vol BASEL Proposed BASEL Proposed
VaR (100.94) (109.42) (96.88) (124.25)
CVA VaR (85.46) - (84.89) -
CCR RC (396.29) 0 (394.07) 0
DRC (190.79) (233.49)
Total (582.70) (300.21) (575.85) (357.75)
CVA 125.43 (149.32) (123.68) (136.47)

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 As shown in the second row of Table 5, VaR is larger than under BASEL because
it includes CVA VaR. However it is less than VaR + CVA VaR under BASEL due to
netting effect between PnLs driven by rates and credit. VaR is much lower compared to
CCR because the trading book is largely hedged for market risk while counterparty risk is
calculated per portfolio. Jump to default risk reflected in DRC is significantly less than
BASEL CCR. The total capital charge under the proposed framework is much lower than
under BASEL.
Note the comparison is simplified as stressed VaR is not calculated. This is because
BASEL only defines stressed VaR but not stressed CVA VaR. If we exclude the shocks to
credit in LSP and only stress the rates, LSP “stressed” VaR under this setting will not be
significantly different than BASEL stressed VaR.
It is more interesting to point out that LSP VaR is sensitive to the correlation
between rates and credit. It is known that the correlation is negative. The historical
correlation using 2007-2009 data of CDX.IG and 10y interest rate is about -0.25. We used
it in the test re-run the capital calculation. The results were similar to the case of zero
correlation. It is noted that VaR is higher under negative correlation. This can be explained
by the fact that higher rates scenarios tend to be accompanied with lower credit. This results
in higher rates PnL offset by lower CVA, a net higher VaR PnL.

7. Conclusion

The post-crisis reform of the regulatory risk framework for OTC derivatives has
settled on a complex and incoherent composition of VaR, stress VaR, CCR, and CVA
capital. And yet, many of the xva innovations have not made into the framework, except
for CVA. As the standard bearer of derivatives counterparty credit risk, CVA capital is
however neither BASEL’s ultimate goal nor a construct free of intense scrutiny from both
the industry and academia.
This article presents an alternative framework that treats uncollateralized or
partially collateralized OTC derivatives in the same way debt instruments are treated via
VaR and default risk charge (DRC). Specifically, we propose to incorporate CVA capital

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into VaR, and CCR’s effect into DRC. CCR and CVA capital can both retire and there is
no need to introduce new risk capital for FVA and other XVAs.
Initial numerical results show various degrees of capital savings, depending on a
derivative portfolio’s counterparty risk exposure profile. Wrong way risk between
exposure and counterparty is more naturally captured and contributes to lessened capital
requirements. This proposal could serve as banks’ economic capital model for OTC
derivatives in the near term. It could develop into an internal model method for regulatory
capital as this demonstrates a capacity of integrating market risk and counterparty credit
risk, allowing us to capture the real economic risk a step closer, while lessening
significantly the implementation burden of the currently risk capital framework.
Extensive and in depth impact studies will be necessary and will be conducted in
the future

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