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Implementation of CVA
PRMIA Credit Valuation Adjustment (CVA) CONGRESS IMPLEMENTATION UND PRAXIS
Köln, 20th July 2011
g.T) Price should be adjusted for default risk ti Time t Et (1-R)e-rt Et ti+1 x + x + … = CVA VRisky(t.T) – CVA (t. Value of Option V(t.T) CVA is correction for credit-risk free calculations! …+x + Probability of Default expected value short rate exposure at time t ti ti+1 Time t 2 recovery rate of counterpart probability of default of the counterpart time of default .T) = V(t.CVA in a nutshell Usually pricing of derivatives does not take the possibility of default into account Exposure E E.
…) TARGET SERVICES REGULATORY CCR Credit Limit Mgt Collateral control CCR Monitoring Concentration Risk reporting CVA CVA desk services CVA Transfer Pricing P&L allocation and control CVA Accounting Exposure Measures Effective EPE/ Stressed EPE (*) CVA VaR (*) • • • • • • Expected Exposure EPE Effective EPE Stressed EPE Marginal EPE PFE RWAs (*) Back-testing Stress Testing (*) Introduced or enriched by Basel III 3 .CVA and CCR Model Macro Process Overview Scenario Generation Market data is received and a set of scenarios is produced with reference to each relevant risk factor/driver The output is a set of evolutions of risk factor scenarios (interest rates. volatilities. CVA. Computation of relevant risk figures/Metrics (Exposure measures. spreads …) Position Revaluation Value computed of every trade comprised in the defined perimeter at any time step for the full set of scenarios Output is a cube of mark-to-futures Output Aggregation Aggregating the mark-to-futures computed along any scenario according to netting and margining agreements.
AUDIT CHECKS. illiquid names PDs) • Historical series storage • Financial models definition for risk factor evolution (scenario generation) • Model calibration with historical (Limit/Regulatory) and risk neutral parameters (for CVA) 7 • Definition of Financial pricing libraries for intraday and batch portfolio revaluation • Intraday to allow CVA desk risk limits control • Batch to measure risk exposures and RWAs • Defines netting nodes and aggregation rules • Management of counterparty specific data (Counterparty Group). mapping Scenario Generation Critical Cross Actitivities RISK MANAGEMENT (CCR) Market Data Scenario Generation Stress tests c/p review/mgt Risk Reporting Wrong way risk assessment Concentration risk 4 5 6 Market Data produc. mark to futures must be aggregated according to the available legal agreements (netting/collateral) in order to get the exposures 6 • Pre-deal: computation of the CVA charge to clients (incremental CVA) • Pre-deal: Credit Limit check based on PFE • Intraday: ‘On demand’ monitoring of CVA and PFE 9 • • • • Regulatory reporting Credit limits reports (PFE) Stress testing results and Wrong way risk Concentration risk (per issuer. Risk Reporting Model define and development Exposures measurement Regulatory reporting Backtesting CVA Desk risk limits monitoring CVA Hedging Greeks Monitoring 3 Output Aggregation P&L measurement DATA MANAGEMENT (INPUT/OUTPUT. …) 1 Risk factor scenario are used to get possible evolution of exposures. Scenario Generation Intraday checks 7 8 9 2 Position Revaluation Exposure Measurement c/p Mgt.CVA and CCR Model Operating Model – Critical activities 1 Scenario Generation CAPITAL MARKET (CVA) Market Data Model define and development Exposure measurement Intraday limit check Intraday CVA Pricing c/p modelling. REPOSITORY. country. a full repricing of the portfolio is needed at each future time grid point until the last expiry date. 2 5 8 3 Once the value of each trade in the portfolio is known until maturity. 4 • Market data acquisition and validation • Unobservable market data computations (correlations. …) 4 . and maint. review and aggr. The same framework can be used for both regulatory purposes (EoD) and intraday trading needs. Based on the risk factor scenarios.
Netting Agreements Trade and Position Data Adjustments Client Onboarding Internal and Regulatory Reporting Legal Agreements Stress Test. Exception Manager P&L Vectors. CVA Sensitivities. Sensitivities Revaluation Engines Trade and Positions Aggregation Engine Exposure CVA. CVA. Limits Limit/CVA Manager. CVA Scenario Generator (support for risk neutral (CVA) and historic (Limit) scenarios) Current Market Data Product Eligibility. Credit) Equities FX and Money Market Repos and Lending Market Data Pre-deal limit check. trade approval. EOD and Intra Day Trading Risk and Valuation Data Controls Fixed Income (Rates.CVA and CCR Functional Model Pre-Deal Limit and CVA Check Limits Exceptions Incremental Credit Exposure. CVA Charge RWA Credit Hierarchies Counterparty Data. CVA Charge Market Data .RWA) Counterparty Data Legal. PDs Netting Agreements Collateral Balances Results Data (Exposure. Back Testing CSAs Collateral Management Controls and Adjustments 5 Trade Data.
CVA Trading Desk .Transaction Lifecycle and Position Valuation Product Control Trading Desks Position Valuation & PnL Client Transaction Risk Free MTM Price / PnL Hedging Valuation & PnL CVA Cash Payment Reconciliation Net Trading Desk Position Hedging Financial Accounting Trading Desk PnL Income Statement CVA Trading Desk Position Valuation & PnL Trading Desk PnL Change in CVA Valuation & CVA Desk PnL CVA Charge Cash Balance CVA Cash Balance Reconciliation CVA Valuation & PnL CVA Hedging Valuation & PnL Change in CVA Valuation & CVA Desk PnL Balance Sheet CVA Valuation CVA Hedging Book Net CVA Desk Cash & Hedge Position OTC Derivative Position MTM Fair Value Adjustment of CVA • Total Net CVA per Counterparty ISDA 6 .
Implementing CVA . buy) Data challenges Define relevant data necessary to calculate and aggregate CVA Business processes Forthcoming regulatory requirements 7 . Passive approach Active approach (profit center ) Passive approach (utility function) •Pricing new trades •Active hedging •What hedging strategies? Mandate of CVA desk? •Pricing new trades •Monitoring of CVA •Accounting CVA IT Architecture (Build vs.practical considerations Active approach vs.
Implementing CVA .practical considerations…cont‘d Methodology Unilateral vs. risk neutral choice of mapping approach Client segmentation observability of clients (liquid vs. bilateral Risk neutral scenarios for exposure calculation blend of market implied and historic market data Modelling of probabilities of default historic vs. illiquid c/p) Wrong way risk design and implementation Gap risk (for CSAs) 8 .
Grade EUR CDS Index Proxy CEE Western Eur Asia Pacific US Single name CDS Sovereigns Itraxx EUR HiVOL Itraxx EUR Non-Fin Itraxx EUR SnrFin Speculative Grade Itraxx EUR Xover Itraxx EUR SnrFin Itraxx SovX CEE Itraxx SovX WE Itraxx SovX AP CDX IG CDX HY AAA AA A BBB BB B CCC 9 . Oil & Gas. Utilities Rating Invest. Consumer Goods.practical considerations…cont‘d Credit Mapping . Industrials. Health Care. Basic Materials. Technology.Implementing CVA . Consumer Services. Telecoms.Example CDS Region Client Type Index Name Sector Financials. Govt.
interest rate swaps.CVA Trading Market risk limits To manage CVA risks the CVA Trading Desk needs to be able to hedge Credit risk: trade any products (credit products. CVA VaR – economic CVA VaR vs Basel III CVA VaR CVA VaR managed by CVA Trading Desk Basel III CVA VaR only for CS01 (for computational reasons).…).g. fx forwards. EPE (Underlying risks on the derivatives): trade instruments relevant for hedging e. still reliable sensitivities helpful to support what-if analysis for hedging Discrepancy between hedging economic CVA VaR (including exposure sensitivities) and Basel III CVA VaR (only CS01) No VaR limit for hedging trades on CVA desk Granular Market Risk Limits Risk metrics/sensitivities have to be produced without excessive noise and proven P&L attributive ability 10 . volatility products. derivatives.
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