REUTERS/Paulo Whitaker Counterparty Credit Risk … · REUTERS/Paulo Whitaker ... BASEL III •...

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Counterparty Credit Risk

James McCann

Director – FX, Rates & Credit

March 2016

REUTERS/Paulo Whitaker

History of Counterparty Credit Risk

DEFAULTS & FINANCIAL SCANDALS

• Asian Crisis

• Russia & LTCM

COUNTERPARTY CREDIT RISK

• Passive risk management

• Some banks price CVA

• No hedging

BASEL I

• Backward looking – focused on existing

situation rather than future

• No advanced measurement of risk

• Simple tier calculations (Tier 1 Capital

ratio 4%)

1990s 2000s2007 & Beyond

• Enron

• WorldCom

• Tyco

• Increased focus on CVA

• Improved computing technology

• SFAS157 points to CVA

BASEL II

• Somewhat forward looking – risk-

sensitive approach to capital

• Three-Pillar risk management

• Lehman

• Banks & Financial Institutions

• Auto Industry

• Accounting standards specify CVA/DVA

• Multi-curve framework

• Central Counterparty Clearing

• xVAs

BASEL III

• Forward looking

• Requirements for higher minimum capital

and capital quality

• Introduced leverage ratios & liquidity risk

Counterparty Credit Risk

“Counterparty credit risk is the risk arising from the possibility that the

counterparty may default on amounts owned on a derivative transaction.

Derivatives are financial instruments that derive their value from the

performance of assets, interest or currency exchange rates, or indexes. They

may include structured debt obligations and deposits, swaps, futures, options,

caps, floors, collars, and forwards, either singly or in various combinations”

OFFICE OF THE COMPTROLLER OF THE CURRENCY (OCC)

U.S. DEPARTMENT OF THE TREASURY

http://www.occ.treas.gov/topics/credit/commercial-credit/counterparty-credit-risk.html

Credit Valuation Adjustment (“CVA”)

“CVA is an adjustment to the fair value (or price) of derivative instruments to

account for counterparty credit risk (CCR). Thus, CVA is commonly viewed

as the price of CCR. This price depends on counterparty credit spreads as

well as on the market risk factors that drive derivatives’ values and, therefore,

exposure”

BASEL COMMITTEE ON BANKING SUPERVISION

BANK FOR INTERNATIONAL SETTLEMENTS

http://www.bis.org/bcbs/publ/d325.pdf

SFAS 157 – “Fair Value Measurements”

“Risk-averse market participants generally seek compensation for bearing the

uncertainty inherent in the cash flows of an asset or liability (risk premium).

A fair value measurement should include a risk premium reflecting the amount market

participants would demand because of the risk (uncertainty) in the cash flows”

“Risk premiums should be reflective of an orderly transaction (that is, not a forced or

distressed sale) between market participants at the measurement date under current

market conditions”

“…the fair value of the liability shall reflect the nonperformance risk relating to that

liability.

Nonperformance risk includes but may not be limited to the reporting entity’s own credit

risk. The reporting entity shall consider the effect of its credit risk (credit standing) on

the fair value of the liability in all periods in which the liability is measured at fair value.”

FINANCIAL ACCOUNTING STANDARDS BOARD

Statement of Financial Accounting Standards No. 157

Credit Valuation Adjustment (“CVA”)

“Under Basel II, the risk of counterparty default and credit migration risk were

addressed but mark-to-market losses due to credit valuation adjustments

(CVA) were not. During the financial crisis, however, roughly two-thirds of

losses attributed to counterparty credit risk were due to CVA losses and only

about one-third were due to actual defaults”

BASEL COMMITTEE ON BANKING SUPERVISION

http://www.bis.org/press/p110601.htm

Derivatives Market

Exchange-traded futures and options

Interest Rate, Dec 2015: 62,950 13%

OTC, interest rate derivatives

H1 2015: 434,740 87%

(in billions of US dollars)

SEMIANNUAL OTC DERIVATIVES STATISTICS

http://www.bis.org/statistics/d7.pdf

http://www.bis.org/statistics/d2.pdf

Total Cleared Since Jan 2015: USD 88,143 billion (82%)

http://www.swapsinfo.org/charts/derivatives/price-transaction

Derivatives MarketCleared, USD-denominated, all Interest Rate Derivatives products, all terms

Total Uncleared Since Jan 2015: USD 18,858 billion (18%)

http://www.swapsinfo.org/charts/derivatives/price-transaction

Derivatives MarketUncleared, USD-denominated, all Interest Rate Derivatives products, all terms

Derivatives Market

ISDA MARGIN SURVEY

https://www2.isda.org/functional-areas/research/surveys/margin-surveys

Fixed-income derivatives: CSA 88.9% No CSA 11.1%

Exchange13%

OTC87%

Cleared82%

Uncleared18%

Collateralized88.9%

Uncollateralized11.1%

Derivatives MarketThe Uncollaterialized Interest Rate Derivatives market is a small portion of the overall market

Note: CSA terms not necessarily standard

The xVAs

• Adjustment to a derivative price due to risk of a counterparty default

• Adjustment to a derivative price due to risk of a own default

• Adjustment to a derivative price due to funding cost/benefit associated with the uncollateralized portion of

derivative portfolios, and in collateralized derivatives where the terms of the agreement do not permit the reuse of

the collateral received

• Adjustment to a derivative price due to the cost of regulatory capital during the life of the trade

• Adjustment due to the optionality inherent in the collateral agreement (ability to choose the currency or type of

collateral to post) and any other non-standard collateral terms

• Adjustment due to posting initial margin for the life of the trade

Methods of Calculating CVA

DURATION METHODOLOGY

• CVA = Mark-to-Market x Duration x Credit Spread

• Simple method

• Single trade or on a portfolio basis

• Potential future exposure is not considered

DISCOUNTED CASH FLOW METHODOLOGY

• CVA = Risk-Free “Fair Value” Price - Credit-Adjusted Price

• Discounting curve is adjusted by appropriate credit spread

• Can apply different credit spreads to assets and liabilities

• Relatively simple method for vanilla trade

• Difficult method for portfolios

• Potential future exposure is not considered

Current Exposure methods

Discount Cash Flows: Fixed Qtrly Money vs 3mLIBORPositive mark-to-market of USD 29,704

Discount Cash FlowsBoth sets of cash flows discounted at LIBOR flat

Discount Cash Flows: IRS with L+100bp CounterpartyCash flows received from Counterparty discounted at LIBOR +100bp

Discount Cash Flows: IRS with L+100bp CounterpartyPositive mark-to-market now USD 27,399, a reduction of USD 2,305

Discount Cash Flows: IRS with L+100bp CounterpartyDiscounting received cash flows at LIBOR+100bp reduces mark-to-market by USD 2,305

SWAPTION METHODOLOGY

• 𝐶𝑉𝐴 = 𝐿𝐺𝐷 ×𝑡=1

𝐷𝑒𝑓𝑎𝑢𝑙𝑡 𝑃𝑟𝑜𝑏𝑎𝑏𝑖𝑙𝑖𝑡𝑦(𝑡−1,𝑡) × 𝑆𝑤𝑎𝑝𝑡𝑖𝑜𝑛 𝑃𝑟𝑒𝑚𝑖𝑢𝑚𝑡

• Expected Loss = (1-Recovery Rate) x Default Probability x Swaption Value

• CVA = Sum of Expected Losses

• Considers Potential Future Exposure as well as Current Exposure

• Can be applied to assets and liabilities

• Only works for interest rate swaps

• Difficult method for portfolios

Expected Exposure methods

Swaption Method: IRS with +100bp CounterpartyCredit adjustment of USD 626 assuming a spread of 100bp

Swaption Method: IRS with +100bp CounterpartyExpected Loss = (1-Recovery Rate) x Default Probability x Swaption Value

Swaption Method: IRS with +100bp CounterpartyA series of swaptions that correspond to the counterparties cash flows are modeled

Swaption Method: IRS with +100bp CounterpartyThe CVA is the sum of all the Expected Losses

Swaption Method: BBB-rated Non-FinancialCDS or Credit Curves can be used that will more accurately reflect the Probabilities of Default for the counterparty

Swaption Method: Fixed Semi Bond vs 3mLIBOR

Swaption Method: CVA & DVAUsing 100bp Spreads for both Self and Counterparty, the CVA and DVA are not equal

Swaption Method: CVA & DVAFor CVA the series of swaptions will be quarterly because Counterparty payments are quarterly

Swaption Method: CVA & DVAFor DVA the series of swaptions will be semi-annually because Self payments are semi-annually – note: higher Def Prob

Swaption Method: Fixed Qtrly Money vs 3mLIBOR

Swaption Method: CVA & DVACVA and DVA are not equal despite same Spread and ATM fixed rate

Swaption Method: CVA & DVAPayer swaptions are used for CVA – the strikes will be 0.9479%, making them all in-the-money so higher value

ATM Fwd

3m 21m 0.9933

6m 18m 1.0317

9m 15m 1.0707

1y 1y 1.1070

15m 9m 1.1414

18m 6m 1.1746

21m 3m 1.2031

Swaption Method: CVA & DVAReceiver swaptions are used for DVA – the strikes will be 0.9479%, making them all out-of-the-money so lower value

ATM Fwd

3m 21m 0.9933

6m 18m 1.0317

9m 15m 1.0707

1y 1y 1.1070

15m 9m 1.1414

18m 6m 1.1746

21m 3m 1.2031

Swaption Method: CVA & DVAReceiver swaptions are used for DVA – the strikes will be 0.9479%, making them all out-of-the-money so lower value

ATM Fwd

3m 21m 0.9933

6m 18m 1.0317

9m 15m 1.0707

1y 1y 1.1070

15m 9m 1.1414

18m 6m 1.1746

21m 3m 1.2031

EXPECTED FUTURE EXPOSURE METHODOLOGY

• 𝐶𝑉𝐴 = 𝐿𝐺𝐷 × ධ0

𝑇𝑑𝐷𝑒𝑓𝑎𝑢𝑙𝑡𝑃𝑟𝑜𝑏𝑎𝑏𝑖𝑙𝑖𝑡𝑦(𝑡) × 𝐸𝑃𝐸(𝑡) × 𝐷𝑖𝑠𝑐𝐹𝑎𝑐𝑡𝑜𝑟(𝑡)

𝐷𝑒𝑓𝑎𝑢𝑙𝑡 𝑃𝑟𝑜𝑏𝑎𝑏𝑖𝑙𝑖𝑡𝑦(𝑡) × 𝐸𝑃𝐸(𝑡) × 𝐷𝑖𝑠𝑐𝐹𝑎𝑐𝑡𝑜𝑟(𝑡)

• Considers Potential Future Exposure as well as Current Exposure

• Can be applied to assets and liabilities

• Single trade or on a portfolio basis (including multiple asset classes)

• Requires complex modeling

• Netting and specific Collateral details can be incorporated into the simulation

• Can be costly to implement

Expected Exposure methods

Cash Flows of Interest Rate Swap

0d 3m 6m 9m 1y 15m 18m 21m 2y

Cash Flows of Interest Rate SwapDiscount back to today

0d 3m 6m 9m 1y 15m 18m 21m 2y

Remaining Cash Flows of Interest Rate SwapIn 3mths the remaining cash flows will be discounted to then

Note: future discount factors & floating cash flows are unknown

0d 3m 6m 9m 1y 15m 18m 21m 2y

Mark-to-Market of Interest Rate Swap Over TimeMark-to-Market is net present value of remaining cash flows

0d 3m 6m 9m 1y 15m 18m 21m 2y

Simulate Multiple ScenariosConsider Positive Exposures

0 2 4 6 8 10

EE = Max(MtM,zero)

NEE = Min(MtM,zero)

0 2 4 6 8 10

Average the Positive ExposuresExpected Exposure profile quantifies the average value of the potential losses as a function of time

Expected Future Exposure MethodFor each period, calculate the product of Default Probability, Expected Exposure, Discount Factor and LGD

Calculate the sum of these values

EXPECTED FUTURE EXPOSURE METHODOLOGY

• 𝐶𝑉𝐴 = 𝐿𝐺𝐷 × ධ0

𝑇𝑑𝐷𝑒𝑓𝑎𝑢𝑙𝑡𝑃𝑟𝑜𝑏𝑎𝑏𝑖𝑙𝑖𝑡𝑦(𝑡) × 𝐸𝑃𝐸(𝑡) × 𝐷𝑖𝑠𝑐𝐹𝑎𝑐𝑡𝑜𝑟(𝑡)

𝐷𝑒𝑓𝑎𝑢𝑙𝑡 𝑃𝑟𝑜𝑏𝑎𝑏𝑖𝑙𝑖𝑡𝑦(𝑡) × 𝐸𝑃𝐸(𝑡) × 𝐷𝑖𝑠𝑐𝐹𝑎𝑐𝑡𝑜𝑟(𝑡)

Expected Exposure MethodFixed Semi Bond vs 3mLIBOR

Expected Exposure Method: Counterparty +100bpFixed Semi Bond vs 3mLIBOR

Exposure determined using a Monte Carlo engine

Expected Exposure Method: Counterparty +100bpFixed Semi Bond vs 3mLIBOR

Expected Exposure Method: Positive Mark-to-MarketPositive NPV: USD 234,244

Expected Exposure Method: Positive Mark-to-MarketExpected Exposure graph reflects positive MtM at inception, with zero exposure by maturity

Negative Exposure (Self) graph begins at zero because positive MtM is ignored

Expected Exposure Method: Positive Mark-to-MarketCredit-Adjusted NPV: USD 201,254

Expected Exposure Method: Positive Mark-to-MarketCVA & DVA: Spread +100bp

Expected Exposure Method: Negative Mark-to-MarketNegative NPV: USD 228,684

Expected Exposure Method: Negative Mark-to-MarketExpected Exposure graph begins at zero because negative MtM is ignored

Negative Exposure (Self) graph reflected negative MtM at inception with zero exposure by maturity

Expected Exposure Method: Negative Mark-to-MarketCredit-Adjusted NPV: USD 248,665

Expected Exposure Method: Negative Mark-to-MarketCVA & DVA: Spread +100bp

Expected Exposure Method: Pay Fixed 10yr IRSCVA: Spread +100bp

Expected Exposure Method: Receive Fixed 10yr IRSCVA: Spread +100bp

Funding Value Adjustment

FUNDING COST ADJUSTMENT (“FCA”)

• Trade with non-CSA counterparty and Hedge with CSA counterparty

• Assume trade between End User and Bank has positive mark-to-market from perspective of Bank, therefore negative MtM on hedge

• No Collateral is posted by the End User but Bank has to post Collateral on the hedge

• If Bank has to post Collateral they will need to fund it

Funding Value Adjustment = Funding Cost Adjustment + Funding Benefit Adjustment

End User Bank Hedge

Post CollateralNo Collateral

Funding Value Adjustment

FUNDING BENEFIT ADJUSTMENT (“FBA”)

• Trade with non-CSA counterparty and Hedge with CSA counterparty

• Assume trade between End User and Bank has negative mark-to-market from perspective of Bank, therefore Positive MtM on hedge

• The Bank gets Collateral posted on the hedge but doesn’t have to post any to the End User

• The Bank is generating funding to the Collateral they have received

• FBA <=> DVA

Funding Value Adjustment = Funding Cost Adjustment + Funding Benefit Adjustment

End User Bank Hedge

Post CollateralNo Collateral

The xVAs

No CSA "Old" CSA CCP

CVA & DVA

Thank you!

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