CVA Fundamentals

Risk Training November 2022

Matthias Arnsdorf

The statements, views and opinions expressed in this article are my own
and do not necessarily reflect those of my employer, JPMorgan Chase & Co.,
its affiliates, other employees or clients.
1
Contents

1. Foundations
 Exposure and Credit Risk Mitigation
2. Valuation
 CVA and other Metrics
3. Modelling
 Scenario Simulation and Trade Pricing
 Default Probabilities and Recoveries
4. Appendix: Advanced Topics
 CVA Charging and Allocation
 CVA Risk Management
 Performance Optimization

2
Foundations:
Introduction
 What is Counterparty Risk?
 … the risk that the counterparty to a transaction could default before the final
settlement of the transaction’s cash flows.
 Quantifying Counterparty Risk:

Credit Exposure
Loss given default of a counterparty in a future market scenario

Risk Limits Valuation Capital

• Potential future exposure ❖ CVA: Value of counterparty risk • Default RWA
• Stressed losses • DVA: Value of own default risk • CVA RWA
• FVA: Value of funding requirements

3
 Portfolio Value Scenarios
Foundations: 0.4
0.3

Exposure 0.2
0.1
EE(t)

0
 Exposure 0 1 2 3 4 5 6
-0.1

 Loss on default assuming zero recovery -0.2

-0.3
 Exposure: 𝐸 𝑡 = max 𝑉 𝑡 , 0 = 𝑉 𝑡 +

 Single trade with no collateral

 V(t) is the risk-free value (mark-to-market) of the trade at time t
 The max makes exposure calculations difficult

 Expected Exposure Profile

 Curve of expected exposure for all future t as of today:
 𝐸𝐸 𝑡 = 𝔼∗ [𝐸(𝑡)|𝑡 = 𝜏]
 Conditional on counterparty defaulting at time 𝒕 = 𝝉
 What is the correct measure for the expectation?
4
 Portfolio Value Scenarios
Foundations: 0.4
0.3

Exposure 0.2
0.1
EE(t)

0
 Exposure 0 1 2 3 4 5 6
-0.1

 Loss on default assuming zero recovery -0.2

-0.3
 Exposure: 𝐸 𝑡 = max 𝑉 𝑡 , 0 = 𝑉 𝑡 +

 Single trade with no collateral

Basic Exposure Profiles
 V(t) is the risk-free value (mark-to-market) of the trade at time t 4.0%
Payment at maturity
3.5%
 The max makes exposure calculations difficult “Square root of time” profile
3.0%
 Expected Exposure Profile 2.5%
2.0%
 Curve of expected exposure for all future t as of today: 1.5%
1.0%
Stream of cashflows
 𝐸𝐸 𝑡 = 𝔼∗ [𝐸(𝑡)|𝑡 = 𝜏] Profile~(𝑇−𝑡) √𝑡
0.5%
 Conditional on counterparty defaulting at time 𝒕 = 𝝉 0.0%
0 2 4 6 8 10 12
 What is the correct measure for the expectation? Fwd Swap

5
Foundations:
Risk Mitigation: Netting
 Close-out Netting
 Contractual agreement allowing the value of multiple trades with one counterparty
to be added prior to making a default claim Value Exposure

 Always risk reducing: V1 V2 No Netting Netting

Scenario 1 20 5 25 25
+ + +
 𝑉1 𝑡 + 𝑉2 𝑡 < 𝑉1 𝑡 + 𝑉2 𝑡 Scenario 2 20 -5 20 15
Scenario 3 -20 5 5 0
Exposure with netting Exposure without netting

 Exposure needs to be calculated at the counterparty portfolio level (netting set)

 To benefit, we need to manage Counterparty Risk centrally
 CCPs
 CCPs offer “multi-lateral” netting – i.e. netting across counterparties

6
Foundations:
Risk Mitigation: Collateral
 Variation Margin
Effect of collateral on exposure
 Collateral to cover daily mark-to-market (MtM) moves. 0.5
 Typically posted/received bilaterally between counterparties
 Retain “Cure period risk”: MtM moves between collateral posting and settlement: 0.4
+ +
 𝐸 𝑡 = V 𝑡 − Collateral 𝑡 = V t −𝑉 t−Δ

 Sensitive to MtM forward volatility over cure period Δ 0.3

 Relevant for Capital and Stress and also in presence of relatedness

 Details of collateral agreement defined in the Credit Support Annex (CSA) 0.2

 Can be very complex and depend on legal jurisdictions

 Initial Margin 0.1

 Additional collateral to cover cure period risk

 Can be static or dynamic 0
0 0.2 0.4 0.6 0.8 1 1.2
 Regulatory mandate for in scope counterparties: Standard Initial Margin Model (SIMM)
+ + -0.1
 𝐸 𝑡 = V 𝑡 − Collateral 𝑡 = V t − 𝑉 t − Δ − IM(𝑡)
MtM Collateral Collateralized exposure
 Exposure with collateral more difficult to model but credit risk is low
7
Foundations:
Risk Mitigation: Collateral
 Variation Margin
Effect of collateral on exposure
 Collateral to cover daily mark-to-market (MtM) moves. 0.5
 Typically posted/received bilaterally between counterparties
 Retain “Cure period risk”: MtM moves between collateral posting and settlement: 0.4
+ +
 𝐸 𝑡 = V 𝑡 − Collateral 𝑡 = V t −𝑉 t−Δ

 Sensitive to MtM forward volatility over cure period Δ 0.3

 Relevant for Capital and Stress and also in presence of relatedness

 Details of collateral agreement defined in the Credit Support Annex (CSA) 0.2

 Can be very complex and depend on legal jurisdictions

 Initial Margin 0.1

 Additional collateral to cover cure period risk

 Can be static or dynamic 0
0 0.2 0.4 0.6 0.8 1 1.2
 Regulatory mandate for in scope counterparties: Standard Initial Margin Model (SIMM)
+ + -0.1
 𝐸 𝑡 = V 𝑡 − Collateral 𝑡 = V t − 𝑉 t − Δ − IM(𝑡)
MtM Collateral Collateralized exposure
 Exposure with collateral more difficult to model but credit risk is low
8
Valuation:
CVA Definition
CVA: Credit Valuation Adjustment = Expected loss due to counterparty default
 Loss: 𝐿 𝑡 = 1 − 𝑅 𝐶 𝐸 𝑡 where 𝑅𝐶 is the counterparty recovery rate
 Define CVA as the value of a derivative with payoff equal to loss on default

CVA=𝔼𝑸 𝑫𝟎 𝝉 𝟏 − 𝑹𝑪 𝑬 𝝉 𝕀𝝉<𝑻
𝑇
 𝐷𝑡 𝑇 = 𝑒 − ‫𝑡׬‬ 𝑟𝑠 𝑑𝑠
is the stochastic discount factor with riskless rate 𝑟𝑡
 𝜏 is the default time of the counterparty and T is the maturity of the derivative
 𝕀 is the indicator function
 𝔼𝑄 is the expectation in the risk neutral measure

 This is “unilateral” CVA as our own default is not considered

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Valuation:
CVA as Valuation Adjustment
Time Payoff 𝑽 > 𝟎 Payoff 𝑽 < 𝟎
 CVA is an adjustment to the risk-free trade value 𝑽𝑹𝑭 Default time 𝜏 < 𝑇 𝑅𝐶 ∙ 𝑉𝑅𝐹 𝜏 𝑉𝑅𝐹 𝜏
 𝑽𝒕𝒐𝒕𝒂𝒍 = 𝑽𝑹𝑭 − 𝑪𝑽𝑨 Maturity 𝜏 > 𝑇 𝑉 𝑇 = Φ(𝑇)
 Allows separation of trading desk and CVA desk
V
 Derivation for derivative with payoff Φ(𝑇) at maturity T:
𝑅𝐶 ∙ 𝑉𝑅𝐹 𝜏 + Φ(𝑇)
𝑄 𝑄 𝐶 + −
 𝑉𝑡𝑜𝑡𝑎𝑙 = 𝔼 D0 T Φ 𝑇 𝕀𝜏>𝑇 + 𝔼 𝐷0 𝜏 (𝑅 𝑉𝑅𝐹 𝜏 − 𝑉𝑅𝐹 𝜏 )𝕀𝜏<𝑇
no default default −
𝜏 𝑇
−𝑉𝑅𝐹 𝜏
𝑄
 𝑉𝑅𝐹 𝑡 = 𝔼t [Dt T Φ T ] and V − = −min(𝑉, 0)

 𝑉𝑡𝑜𝑡𝑎𝑙 = 𝔼𝑄 D0 T Φ 𝑇 − 𝔼𝑄 𝐷0 𝜏 1 − 𝑅 𝐶 𝐸 𝜏 𝕀𝜏<𝑇 = 𝑉𝑅𝐹 − 𝐶𝑉𝐴

 Use:
 𝑅𝐶 𝑉𝑅𝐹 𝜏 +
− 𝑉𝑅𝐹 𝜏 −
= 𝑉𝑅𝐹 𝜏 − 1 − 𝑅𝐶 𝑉𝑅𝐹 𝜏 +

𝑄 𝑄
 𝔼𝑄 𝐷0 𝜏 𝔼𝜏 [D𝜏 𝑇 Φ 𝑇 ]𝕀𝜏<𝑇 =𝔼𝑄 𝔼𝜏 [𝐷0 𝜏 D𝜏 𝑇 Φ 𝑇 𝕀𝜏<𝑇 ] =𝔼𝑄 D0 T Φ 𝑇 𝕀𝜏<𝑇
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Valuation:
CVA as Valuation Adjustment
Time Payoff 𝑽 > 𝟎 Payoff 𝑽 < 𝟎
 CVA is an adjustment to the risk-free trade value 𝑽𝑹𝑭 Default time 𝜏 < 𝑇 𝑅𝐶 ∙ 𝑉𝑅𝐹 𝜏 𝑉𝑅𝐹 𝜏
 𝑽𝒕𝒐𝒕𝒂𝒍 = 𝑽𝑹𝑭 − 𝑪𝑽𝑨 Maturity 𝜏 > 𝑇 𝑉 𝑇 = Φ(𝑇)
 Allows separation of trading desk and CVA desk
V
 Derivation for derivative with payoff Φ(𝑇) at maturity T:
𝑅𝐶 ∙ 𝑉𝑅𝐹 𝜏 + Φ(𝑇)
𝑄 𝑄 𝐶 + −
 𝑉𝑡𝑜𝑡𝑎𝑙 = 𝔼 D0 T Φ 𝑇 𝕀𝜏>𝑇 + 𝔼 𝐷0 𝜏 (𝑅 𝑉𝑅𝐹 𝜏 − 𝑉𝑅𝐹 𝜏 )𝕀𝜏<𝑇
no default default −
𝜏 𝑇
−𝑉𝑅𝐹 𝜏
𝑄
 𝑉𝑅𝐹 𝑡 = 𝔼t [Dt T Φ T ] and V − = −min(𝑉, 0)

 𝑉𝑡𝑜𝑡𝑎𝑙 = 𝔼𝑄 D0 T Φ 𝑇 − 𝔼𝑄 𝐷0 𝜏 1 − 𝑅 𝐶 𝐸 𝜏 𝕀𝜏<𝑇 = 𝑉𝑅𝐹 − 𝐶𝑉𝐴

 Use:
 𝑅𝐶 𝑉𝑅𝐹 𝜏 +
− 𝑉𝑅𝐹 𝜏 −
= 𝑉𝑅𝐹 𝜏 − 1 − 𝑅𝐶 𝑉𝑅𝐹 𝜏 +

𝑄 𝑄
 𝔼𝑄 𝐷0 𝜏 𝔼𝜏 [D𝜏 𝑇 Φ 𝑇 ]𝕀𝜏<𝑇 =𝔼𝑄 𝔼𝜏 [𝐷0 𝜏 D𝜏 𝑇 Φ 𝑇 𝕀𝜏<𝑇 ] =𝔼𝑄 D0 T Φ 𝑇 𝕀𝜏<𝑇
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Valuation:
CVA as a stream of CDS
 CVA can be valued as the contingent leg of a CDS with time varying notional
 CVA=𝔼𝑄 𝐷0 𝜏 1 − 𝑅𝐶 𝐸 𝜏 𝕀𝜏<𝑇 CDS flows Default payment (1-R)N
𝑇
 CVA= 1 − 𝑅𝐶 ‫׬‬0 𝔼𝑄 𝐷0 𝑡 𝐸 𝑡 |𝜏 = 𝑡 𝑃𝐶 𝜏 = 𝑡 𝑑𝑡 contingent leg
𝜏
𝑪 𝑻 𝑪 fee leg
 CVA= 𝟏 − 𝑹 ‫𝑩 𝟎׬‬ 𝟎, 𝒕 𝑬𝑬 𝒕 𝑷 𝝉 = 𝒕 𝒅𝒕 Coupon payments cN
 Where:
 𝐵 0, 𝑡 = 𝔼𝑄 𝐷0 𝑡 is the zero-coupon bond price
𝐷0 𝑡
 𝐸𝐸 𝑡 = 𝔼𝑄 𝐸 𝑡 |𝜏 = 𝑡 = 𝔼𝐹 𝐸 𝑡 |𝜏 = 𝑡 is the expected exposure
𝐵 0,𝑡

 𝔼𝐹 is the so-called t-forward measure

𝑡 𝐶
 𝑃𝐶 𝜏 = 𝑡 𝑑𝑡 = 𝜆𝐶 𝑡 𝑒 − ‫׬‬0 𝜆 𝑠 𝑑𝑠
𝑑𝑡 = 𝜆𝐶 𝑡 𝑄𝐶 𝑡 𝑑𝑡 is counterparty default prob in interval (t, t+dt)
 𝜆𝐶 𝑡 is the instantaneous default rate of the counterparty (Poisson intensity)
 𝑄 𝐶 (𝑡) is the counterparty survival probability

 CVA can be replicated with a term structure of CDS 12

Valuation:
Other Metrics
What if we (Bank B) can default as well as the counterparty C?
 Bilateral CVA: Need to condition on our own survival
𝑻
 BCVA = 𝟏 − 𝑹𝑪 ‫𝟎 𝑩 𝟎׬‬, 𝒕 𝑬𝑬 𝒕 𝝀𝑪 𝒕 𝑸𝑪 𝒕 𝑸𝑩 𝒕 𝒅𝒕
𝑡 𝐵
 𝑄 𝐵 (𝑡) = 𝑒 − ‫׬‬0 𝜆 𝑠 𝑑𝑠
is our (the Bank’s) survival probability up to t
 DVA: CVA viewed from the point of view of the counterparty
 Benefit to issuing bank (on bank default). Required to achieve symmetric valuation
𝑻
 DVA = − 𝟏 − 𝑹𝑩 ‫𝟎 𝑩 𝟎׬‬, 𝒕 𝑬𝑬− 𝒕 𝝀𝑩 𝒕 𝑸𝑩 𝒕 𝑸𝑪 𝒕 𝒅𝒕
 Negative expected exposure: 𝐸𝐸 − 𝑡 = − min 𝐸 𝑡 , 0
 FVA: Cost of funding uncollateralized trades
 Can be cost (FCA) and benefit (FBA)
 FBA overlaps with DVA. Component of DVA that can be monetized
 FCA is firm specific (depends on firm’s funding cost). Breaks valuation symmetry
𝑻
 FVA = 𝟏 − 𝑹𝑩 ‫𝟎 𝑩 𝟎׬‬, 𝒕 (𝑬𝑬 𝒕 − 𝑬𝑬− 𝒕 )𝝀𝑩 𝒕 𝑸𝑩 𝒕 𝑸𝑪 𝒕 𝒅𝒕 13
Valuation:
Other Metrics
What if we (Bank B) can default as well as the counterparty C?
 Bilateral CVA: Need to condition on our own survival
𝑻
 BCVA = 𝟏 − 𝑹𝑪 ‫𝟎 𝑩 𝟎׬‬, 𝒕 𝑬𝑬 𝒕 𝝀𝑪 𝒕 𝑸𝑪 𝒕 𝑸𝑩 𝒕 𝒅𝒕
𝑡 𝐵
 𝑄 𝐵 (𝑡) = 𝑒 − ‫׬‬0 𝜆 𝑠 𝑑𝑠
is our (the Bank’s) survival probability up to t
 DVA: CVA viewed from the point of view of the counterparty
 Benefit to issuing bank (on bank default). Required to achieve symmetric valuation
𝑻
 DVA = − 𝟏 − 𝑹𝑩 ‫𝟎 𝑩 𝟎׬‬, 𝒕 𝑬𝑬− 𝒕 𝝀𝑩 𝒕 𝑸𝑩 𝒕 𝑸𝑪 𝒕 𝒅𝒕
 Negative expected exposure: 𝐸𝐸 − 𝑡 = − min 𝐸 𝑡 , 0
 FVA: Cost of funding uncollateralized trades
 Can be cost (FCA) and benefit (FBA)
 FBA overlaps with DVA. Component of DVA that can be monetized
 FCA is firm specific (depends on firm’s funding cost). Breaks valuation symmetry
𝑻
 FVA = 𝟏 − 𝑹𝑩 ‫𝟎 𝑩 𝟎׬‬, 𝒕 (𝑬𝑬 𝒕 − 𝑬𝑬− 𝒕 )𝝀𝑩 𝒕 𝑸𝑩 𝒕 𝑸𝑪 𝒕 𝒅𝒕 14
Valuation:
Other Metrics
What if we (Bank B) can default as well as the counterparty C?
 Bilateral CVA: Need to condition on our own survival
𝑻
 BCVA = 𝟏 − 𝑹𝑪 ‫𝟎 𝑩 𝟎׬‬, 𝒕 𝑬𝑬 𝒕 𝝀𝑪 𝒕 𝑸𝑪 𝒕 𝑸𝑩 𝒕 𝒅𝒕
𝑡 𝐵
 𝑄 𝐵 (𝑡) = 𝑒 − ‫׬‬0 𝜆 𝑠 𝑑𝑠
is our (the Bank’s) survival probability up to t
 DVA: CVA viewed from the point of view of the counterparty
 Benefit to issuing bank (on bank default). Required to achieve symmetric valuation
𝑻
 DVA = − 𝟏 − 𝑹𝑩 ‫𝟎 𝑩 𝟎׬‬, 𝒕 𝑬𝑬− 𝒕 𝝀𝑩 𝒕 𝑸𝑩 𝒕 𝑸𝑪 𝒕 𝒅𝒕
 Negative expected exposure: 𝐸𝐸 − 𝑡 = − min 𝐸 𝑡 , 0
 FVA: Cost of funding uncollateralized trades
 Can be cost (FCA) and benefit (FBA)
 FBA overlaps with DVA. Component of DVA that can be monetized
 FCA is firm specific (depends on firm’s funding cost). Breaks valuation symmetry
𝑻
 FVA = 𝟏 − 𝑹𝑩 ‫𝟎 𝑩 𝟎׬‬, 𝒕 (𝑬𝑬 𝒕 − 𝑬𝑬− 𝒕 )𝝀𝑩 𝒕 𝑸𝑩 𝒕 𝑸𝑪 𝒕 𝒅𝒕 15
Valuation:
Other Metrics
What if we (Bank B) can default as well as the counterparty C?
 Bilateral CVA: Need to condition on our own survival
𝑻
 BCVA = 𝟏 − 𝑹𝑪 ‫𝟎 𝑩 𝟎׬‬, 𝒕 𝑬𝑬 𝒕 𝝀𝑪 𝒕 𝑸𝑪 𝒕 𝑸𝑩 𝒕 𝒅𝒕
𝑡 𝐵
 𝑄 𝐵 (𝑡) = 𝑒 − ‫׬‬0 𝜆 𝑠 𝑑𝑠
is our (the Bank’s) survival probability up to t
 DVA: CVA viewed from the point of view of the counterparty
 Benefit to issuing bank (on bank default). Required to achieve symmetric valuation
𝑻
 DVA = − 𝟏 − 𝑹𝑩 ‫𝟎 𝑩 𝟎׬‬, 𝒕 𝑬𝑬− 𝒕 𝝀𝑩 𝒕 𝑸𝑩 𝒕 𝑸𝑪 𝒕 𝒅𝒕
 Negative expected exposure: 𝐸𝐸 − 𝑡 = − min 𝐸 𝑡 , 0
 FVA: Cost of funding uncollateralized trades
 Can be cost (FCA) and benefit (FBA)
 FBA overlaps with DVA. Component of DVA that can be monetized
 FCA is firm specific (depends on firm’s funding cost). Breaks valuation symmetry
𝑻
 FVA = 𝟏 − 𝑹𝑩 ‫𝟎 𝑩 𝟎׬‬, 𝒕 (𝑬𝑬 𝒕 − 𝑬𝑬− 𝒕 )𝝀𝑩 𝒕 𝑸𝑩 𝒕 𝑸𝑪 𝒕 𝒅𝒕 16
Modelling:
Overview
 CVA is typically calculated centrally and at a counterparty portfolio level

• Generate market scenarios using Monte Carlo simulation

Simulation

• In each scenario and a selection of future dates value all trades for all portfolios
Pricing

• For each path and date compute exposure incorporating collateral and netting
Aggregation

• Use EE profile, counterparty spreads and recoveries to calculate derived metrics

Valuation
• CVA, DVA, FVA, EEPE…

17
Modelling:
Simulation IR
• Two factor mean reverting short rate model e.g.
Hull-White
 High level model requirements: • Capture curve moves
• Capture Smile. Stochastic vol?
 Require cross-asset model for all relevant
risk factors FX
• E.g. Geometric Brownian motion
 Use models consistent with Line-of-Business • Capture Smile. Stochastic vol?
(LOB) pricing models where possible
Equites
 preserve martingale property
• E.g. Geometric Brownian motion
 Low factor diffusion models typically • Factor model
sufficient • Stochastic vol for option products
 Introduce factor structure to deal with large Credit
number of risk factors
• E.g. stochastic spread model
 Correlate Brownian drivers of major factors • Capture default dependency with copula or jumps
 Use backtesting to validate simulation model Commodities
adequacy
• E.g. mean reverting model capturing seasonality
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Modelling:
Calibration
Risk Neutral
Measure
Calibrate to market implied
data where available
•Includes most volatilities
Historical calibrations are
possible as a fall-back
•Required for market factor correlations
Portfolio Long
Level Horizon
Cannot optimize calibration to
target particular product types
Liquid option data is limited
•E.g. short horizon vs. long horizon,
moneyness…
Target best fit across various
trade types Require suitable volatility
•Optimize choice of calibration targets extrapolation
Bespoke calibrations for Make use of fact that exposure
specific counterparties is quickly reduces for long
possible horizons
19
Modelling:
Pricing
 All portfolio trades need to be valued in all simulated scenarios
 Discretize timeline out to the final portfolio maturity and value at chosen exposure points
 Key pricing requirement is match to LOB valuations
 Trade pricing is critical compute constraint
 Need to find optimum balance between accuracy and efficiency

Closed Form Pricers

• Majority of products are quick to value, e.g. IR swaps.

• Can use be-spoke closed form pricers or use LOB models directly
• Need to deal with multiple LOB systems

Approximate Fast Pricers

• For exotic trades priced using Monte Carlo or PDEs, exact pricing is expensive

Regression based pricers American-Monte-Carlo Machine Learning

•Use parametric or non-parametric •Use the trade payoff as well as the •Estimate pricing function by using
techniques to regress trade values scenario MC simulation to estimate LOB valuation as training data
against the main market drivers and trade values using AMC techniques 20
time
Modelling:
Spreads and Recoveries
Default Probabilities
 Use market implied counterparty default
probabilities for valuation
 Bootstrap probabilities from CDS spreads if
available
 Spread = 1 − 𝑅 𝜆
 Few counterparties will have liquid CDS
 Use “proxy” spreads
 Related counterparties
 Indices
 Or interpolate spreads using:
 Rating, industry & sectorial classifications
 Bond data. Equity?
 Use regression or ML techniques
 Risk management will rely on indices or proxy
CDS (macro hedging) 21
Modelling:
Spreads and Recoveries
Default Probabilities Recovery rates
 Use market implied counterparty default  Market credit spreads typically imply a fixed
probabilities for valuation recovery of around 40%.
 Bootstrap probabilities from CDS spreads if  Market recovery rate should be used for
available bootstrapping default probabilities
 Spread = 1 − 𝑅 𝜆  Market recovery rates refer to bond recoveries
 Few counterparties will have liquid CDS 𝑇 𝑡 𝐶
 CVA= 1 − 𝑅𝐶 ‫׬‬0 𝐵 0, 𝑡 𝐸𝐸 𝑡 𝜆𝐶 𝑡 𝑒 − ‫׬‬0 𝜆 𝑠 𝑑𝑠
𝑑𝑡
 Use “proxy” spreads
 Recovery rate for derivative may be different
 Related counterparties
 Derivatives are bilateral instruments and typically
 Indices pari-passu with loans
 Or interpolate spreads using:
 Rating, industry & sectorial classifications
 Bond data. Equity?
 Use regression or ML techniques
 Risk management will rely on indices or proxy
CDS (macro hedging) 22
Conclusion

 Counterparty risk is the default risk for derivatives portfolios

 CVA is an adjustment to the risk-free trade value to account for counterparty risk
 CVA calculation is similar to pricing an exotic derivative
 Presence of netting and collateral requires portfolio level risk management
 Exposure calculations are highly compute intensive and require advanced
software and hardware
 XVA risk management in particular focus in times of crisis

23
Advanced Topics: Client X
Client Y

CVA Charging and Allocation

CVA charge
MtM

Desk A
Manage risk free
MtM
 To capture portfolio level collateral terms and
benefit from netting:
 Calculate CVA at counterparty level Default insurance CVA charge

 Calculate and risk manage CVA centrally

 CVA desk insures defaults in return for the CVA charge
 However, client charges are at trade level and XVA Desk
CVA Risk
managed by business units Management
 Require trade allocation for CVA
 Incremental (marginal) exposure for trade A:
+ +
 𝐸𝐸𝐴 𝑡 = 𝔼 𝑉𝐴 𝑡 + 𝑉𝑁𝐶 − 𝔼 𝑉𝑁𝐶
 Netting set value VNC = σ𝑖 𝑉(𝑡)
Desk C
Desk B
 Depends on order of trades
 Requires optimization of compute & memory overhead Client Y
 Precompute 𝑉𝑁𝐶 for each counterparty
Client X Client Z 24
Advanced Topics:
Risk Management
 A CVA trading desk will calculate a number of metrics for risk management
 CVA Greeks/Sensitivities: 𝜕𝐶𝑉𝐴ൗ𝑑𝑋𝑖
𝜕𝐶𝑉𝐴
 P&L Explain and Predict: 𝐶𝑉𝐴 𝑡 ≈ 𝐶𝑉𝐴 𝑡 − Δt + σ𝑖 ΔXi
𝑑𝑋𝑖

 CVA VaR and Stress: quantile in CVA distribution or CVA in specific stress scenario

Spread Risk:

• CVA is linear in spreads. Risk is efficient to compute

• Hedge with CDS either single name or index (macro hedging)
• Can only hedge idiosyncratic default risk when counterparty has liquid CDS instruments
• Otherwise can only hedge spread MtM risk

Market Risk

• Large number of risk factors. Each risk factor sensitivity requires full re-valuation
• Equivalent to exotic derivative hedging
• Very expensive if not optimized e.g. using analytic sensitivities (AAD)
• Focus on key risk drivers, e.g. IR, FX. Hedge using swaps and options 25
Advanced Topics:
Performance
 Credit Exposure calculations are highly compute intensive.
 E.g. 1M trades, 10k paths, 100 time points -> 1Trillion evaluations
 Assume 1ms per trade -> require 275k CPU hours
 Require cutting edge compute architecture:

Code Optimization Hardware

• Fast pricers • Parallelization

• Monte Carlo variance • GPUs
reduction • Cloud Computing
• Analytical Adjoint • Large memory machines
Differentiation (AAD) • Quantum computing…
• Trade compression
26
Advanced Topics:
Wrong-Way-Risk
 Expected Exposure is conditional on default
 𝐸𝐸 𝑡 = 𝔼∗ [𝐸(𝑡)|𝜏 = 𝑡]
 Need to consider relatedness between the trade MtM and counterparty default
 Examples:
 Equity: A bank buys a put on the counterparty’s stock
 FX: A bank enters a COP/USD swap with a Colombian bank. If COP gets devalued,
the counterparty is likely to default.
 Commodities: A bank enters a natural gas forward with a gas producer
 Credit: A bank buys CDS protection on name ‘A’ from counterparty ‘B’ working in
the same industry as ‘A’

27
Advanced Topics:
Wrong-Way-Risk: Spread relatedness
 Derive relatedness between counterparty spreads and market factor:
 𝐸𝐸 𝑡 = 𝔼∗ 𝐸 𝑡 𝜏 = 𝑡 = ‫𝜔𝑑 𝑡 = 𝜏 𝜔 𝑃 𝑡 𝐸 ׬‬
 Bayes rule: 𝑃 𝜔 𝜏 = 𝑡 P(𝜏 = 𝑡) = P 𝜏 = 𝑡 𝜔 𝑃 𝜔
1 1
 𝐸𝐸 𝑡 = ‫׬‬ 𝐸 𝑡 P 𝜏 = 𝑡 𝜔 𝑃 𝜔 𝑑𝜔 = 𝔼∗ [E t P(𝜏 = 𝑡|𝜔)]
𝑃(𝜏=𝑡) 𝑃(𝜏=𝑡)

 Make assumption that market factors only depend on the counterparty default via
the spread s.
 Assume standard “Cox process” for default intensity 𝜆 (conditional independence):
𝑡
 𝑃 𝜏 = 𝑡 𝜔 = 𝜆 𝑡; 𝜔 exp − ‫׬‬0 𝜆 𝑠; 𝜔 𝑑𝑠

 This can be calculated on each Monte Carlo path if we have a joint simulation of
credit spreads and market factors

28
Advanced Topics:
Margin
 Initial Margin is increasingly common due to introduction of Regulatory margin
requirements: SIMM
 In presence of initial margin, counterparty risk is largely eliminated
 CVA will be close to zero
 To receive margin benefit for regulatory capital and to model stress exposure a
model for IM is needed. Also needed for funding cost calculations
 Require projection of IM amortization over portfolio lifetime
 Modelling options:
 Deterministic projection: e.g. flat or straight-line amortization
 Risk based projection: estimate future margin as function of portfolio risk calculated
using the exposure simulation. Can used regression or ML techniques
 Full re-valuation: Re-value IM exactly for each scenario and timeline point
 Underestimation of received IM is conservative

29
Advanced Topics:
Hedging in a Crisis
 Covid crisis resulted in extreme credit spreads together with large
market swings. Unique challenge for risk management
 Rapid market moves required intra-day re-hedging and hence
sensitivity re-valuation
 Require sensitivity predicts e.g. with second order Greeks
 CDS liquidity insufficient for large volume of hedging required across
industry
 Increases bid-offer and results in negative feedback for spread levels
 Index (macro) hedges not closely coupled to single name performance. Most
risk in smaller firms
 Require wider range of alternative credit hedging instruments
 What about defaults?
 Increased number of defaults due to crisis
 Concentrated in particular sectors, e.g. energy, aviation
 Macro hedging does not provide full protection for the idiosyncratic risk
 Make use of diversification and systemic hedges

30