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Counterparty credit risk and credit value adjustment
a continuing challenge for global financial markets
1 online resource (xxii, 455 pages : : illustrations.)
Failures of large financial institutions and sovereigns, leading to bankruptcies and dramatic bailouts have thrust counterparty credit risk heavily into the spotlight as the key element of financial risk management. The sudden realisation of extensive counterparty risks has severely compromised the balance sheets of banks globally, the health of global financial markets and state of the general economy. Understanding and managing counterparty risk and CVA (credit value adjustment) has become a key problem for all financial institutions. Counterparty Credit Risk and Credit Value Adjustment: A Continuing Challenge for Global Financial Markets, Second Edition explains the history of the subject and its emergence as the key financial risk during the global financial crisis. The basics of counterparty risk management, including aspects such as potential future exposure, netting and collateral, are defined. Banks and other financial institutions have been developing their capabilities for pricing counterparty risk and these elements are considered in detail via a characterisation of credit value adjustment. Wrong-way counterparty risks are addressed in detail in relation to interest rate, foreign exchange, commodity and credit derivative products and regulatory capital for counterparty risk, including the recent Basel III requirements for CVA VAR is discussed. The implications of an institution valuing their own default via debt value adjustment (DVA) and funding costs (FVA) are also considered at length. The management of counterparty risk within an institution by a CVA desk is also discussed with the associated portfolio management and hedging of CVA described in full. Finally, the design and benefits of central clearing, a recent development to attempt to control the rapid growth of counterparty risk, is considered. The first edition of this book has become a standard reference on the subject of counterparty credit risk. The second edition has been completely re-written to cover the recent extensive changes in theory, market practice and regulation and the new topics of risk-free valuation, funding considerations and Basel III capital requirements. The book is unique in being practically focused but also covers the more technical aspects. It is an invaluable complete reference guide for any market practitioner, policy maker, academic or student with any responsibility or interest within the area of counterparty credit risk and CVA. The book has a supporting website, www.cvacentral.com, which contains spreadsheets, mathematical appendices and other supporting documentation, all of which are freely downloadable.
SECTION I INTRODUCTION -- 1. Introduction -- 2. Background -- 2.1. Introduction -- 2.2. Financial risk -- 2.2.1. Market risk -- 2.2.2. Credit risk -- 2.2.3. Liquidity risk -- 2.2.4. Operational risk -- 2.2.5. Integration of risk types -- 2.3. Value-at-Risk -- 2.3.1. Definition -- 2.3.2. The dangers of VAR -- 2.3.3. Models -- 2.3.4. Correlation and dependency -- 2.4. The derivatives market -- 2.4.1. Uses of derivatives -- 2.4.2. Exchange-traded and OTC derivatives -- 2.4.3. Risks of derivatives -- 2.4.4. Too big to fail and systemic risk -- 2.4.5. Credit derivatives -- 2.5. Counterparty risk in context -- 2.5.1. The rise of counterparty risk -- 2.5.2. Counterparty risk and CVA -- 2.5.3. Mitigating counterparty risk -- 2.5.4. Counterparty risk and central clearing -- 2.6. Summary -- 3. Denning Counterparty Credit Risk -- 3.1. Introducing counterparty credit risk -- 3.1.1. Counterparty risk versus lending risk -- 3.1.2. Settlement and pre- settlement risk -- 3.1.3. Exchange-traded derivatives -- 3.1.4. OTC-traded derivatives -- 3.1.5. Repos and securities lending -- 3.1.6. Mitigating counterparty risk -- 3.1.7. Counterparty risk, players -- 3.2. Components and terminology -- 3.2.1. Credit exposure -- 3.2.2. Default probability, credit migration and credit spreads -- 3.2.3. Recovery and loss given default -- 3.2.4. Mark-to-market and replacement cost -- 3.2.5. Mitigating counterparty risk -- 3.3. Control and quantification -- 3.3.1. Credit limits -- 3.3.2. Credit value adjustment -- 3.3.3. CVA or credit limits? -- 3.3.4. What does CVA represent? -- 3.3.5. Hedging counterparty risk -- 3.3.6. Portfolio counterparty risk -- 3.4. Summary -- SECTION II MITIGATION OF COUNTERPARTY CREDIT RISK -- 4. Netting, Compression, Resets and Termination Features -- 4.1. Introduction -- 4.1.1. The origins of counterparty risk -- 4.1.2. The ISDA master agreement -- 4.2. Netting -- 4.2.1. Payment netting -- 4.2.2. The need for closeout netting -- 4.2.3. Closeout netting -- 4.2.4. Netting sets and subadditivity -- 4.2.5. The impact of netting -- 4.2.6. Product coverage -- 4.3. Termination features and trade compression -- 4.3.1. Reset agreements -- 4.3.2. Additional termination events -- 4.3.3. Walkaway features -- 4.3.4. Trade compression and multilateral netting -- 4.4. Conclusion -- 5. Collateral -- 5.1. Introduction -- 5.1.1. Rationale for collateral -- 5.1.2. Analogy with mortgages -- 5.1.3. The basics of collateralisation -- 5.1.4. Collateral usage -- 5.1.5. The credit support annex -- 5.1.6. Impact of collateral -- 5.2. Collateral terms -- 5.2.1. Valuation agent -- 5.2.2. Types of collateral -- 5.2.3. Coverage of collateralisation -- 5.2.4. Disputes and reconciliations -- 5.2.5. Margin call frequency -- 5.2.6. Haircuts -- 5.2.7. Coupons and interest payments -- 5.2.8. Substitution, funding costs and rehypothecation -- 5.3. Denning the amount of collateral -- 5.3.1. Types of CSA -- 5.3.2. Linkage of collateral parameters to credit quality -- 5.3.3. Threshold -- 5.3.4. Independent amount -- 5.3.5. Minimum transfer amount and rounding -- 5.4. The risks of collateralisation -- 5.4.1. Market risk and the margin period of risk -- 5.4.2. Operational risk -- 5.4.3. Liquidity risk -- 5.4.4. Funding liquidity risk -- 5.5. Summary -- 6. Default Remote Entities and the Too Big to Fail Problem -- 6.1. Introduction -- 6.1.1. Default remoteness and too big to fail -- 6.1.2. From OTC to exchange-traded -- 6.2. Special purpose vehicles -- 6.3. Derivative product companies -- 6.3.1. Standard DPCs -- 6.3.2. The decline of DPCs -- 6.4. Monolines and credit DPCs -- 6.4.1. Rationale -- 6.4.2. Monoline insurers -- 6.4.3. Credit derivative product company -- 6.4.4. The massive monoline failure -- 6.4.5. Why the rating agencies got it wrong -- 6.4.6. A (very simple) quantitative analysis of monolines -- 6.5. Central counterparties -- 6.5.1. Introduction -- 6.5.2. Exchanges and clearing -- 6.5.3. Basics of central clearing -- 7. Central Counterparties -- 7.1. Centralised clearing -- 7.1.1. Systemic risk -- 7.1.2. The impact of the crisis -- 7.1.3. CCPs in perspective -- 7.1.4. Function of a CCP -- 7.1.5. Multilateral netting -- 7.1.6. How many CCPs? -- 7.1.7. Coverage of CCPs -- 7.2. Logistics of central clearing -- 7.2.1. Clearing members -- 7.2.2. Variation margin -- 7.2.3. Impact of default of a CCP member -- 7.2.4. Initial margin -- 7.2.5. Reserve funds, capital calls and loss mutualisation -- 7.2.6. Interoperability -- 7.2.7. Non-clearing members and end-users -- 7.3. Analysis of the impact and benefits of CCPs -- 7.3.1. The advantage of centralised clearing -- 7.3.2. Have CCPs failed before? -- 7.3.3. The impact of homogenisation -- 7.3.4. Will a CCP be allowed to fail? -- 7.3.5. Could OTC derivatives survive without CCPs? -- 7.3.6. Hurdles and challenges for the growth of the CCP market -- 7.4. Conclusions -- 8. Credit Exposure -- 8.1. Credit exposure -- 8.1.1. Definition -- 8.1.2. Bilateral exposure -- 8.1.3. The closeout amount -- 8.1.4. Exposure as a short option position -- 8.1.5. Future exposure -- 8.1.6. Comparison to value-at-risk -- 8.2. Metrics for credit exposure -- 8.2.1. Expected future value -- 8.2.2. Potential future exposure -- 8.2.3. Expected exposure -- 8.2.4. EE and PFE for a normal distribution -- 8.2.5. Maximum PFE -- 8.2.6. Expected positive exposure -- 8.2.7. Negative exposure -- 8.2.8. Effective expected positive exposure -- 8.3. Factors driving credit exposure -- 8.3.1. Loans and bonds -- 8.3.2. Future uncertainty -- 8.3.3. Periodic cash flows -- 8.3.4. Combination of profiles -- 8.3.5. Optionality -- 8.3.6. Credit derivatives -- 8.4. Understanding the impact of netting on exposure -- 8.4.1. The impact of netting on future exposure -- 8.4.2. Netting and the impact of correlation -- 8.4.3. Netting and absolute value -- 8.5. Credit exposure and collateral -- 8.5.1. How much collateral? -- 8.5.2. Margin period of risk -- 8.5.3. Impact of collateral on exposure -- 8.5.4. Repos and overcollateralisation -- 8.6. Risk-neutral or real-world? -- 8.6.1. The importance of measure -- 8.6.2. Drift -- 8.6.3. Volatility -- 8.6.4. Correlations -- 8.6.5. Conclusion -- 8.7. Summary -- SECTION III CREDIT VALUE ADJUSTMENT -- 9. Quantifying Credit Exposure -- 9.1. Introduction -- 9.2. Methods for quantifying credit exposure -- 9.2.1. Add-ons -- 9.2.2. Semi-analytical methods -- 9.2.3. Monte Carlo simulation -- 9.3. Monte Carlo methodology -- 9.3.1. Simulation model -- 9.3.2. Scenario generation -- 9.3.3. Revaluation -- 9.3.4. Aggregation -- 9.3.5. Post-processing -- 9.3.6. Extraction -- 9.4. Models for credit exposure -- 9.4.1. Risk-neutral vs real-world -- 9.4.2. Interest rates -- 9.4.3. FX and inflation -- 9.4.4. Commodities -- 9.4.5. Credit spreads -- 9.4.6. Equities -- 9.4.7. Conelations -- 9.4.8. Stochastic volatility -- 9.5. Netting examples -- 9.5.1. Examples -- 9.5.2. Exposure profiles -- 9.6. Allocating exposure -- 9.6.1. Simple two-trade, single-period example -- 9.6.2. Incremental exposure -- 9.6.3. Marginal exposure -- 9.6.4. Calculation of incremental and marginal exposure -- 9.7. Exposure and collateral -- 9.7.1. Collateral assumptions -- 9.7.2. Base case example -- 9.7.3. Impact of margin period of risk -- 9.7.4. Impact of threshold and independent amount -- 9.7.5. Are two-way CSAs always beneficial? -- 9.7.6. Non-cash collateral -- 9.8. Summary -- 10. Default Probability, Credit Spreads and Credit Derivatives -- 10.1. Default probability and recovery rates -- 10.1.1. Defining default probability -- 10.1.2. Real and risk-neutral default probabilities -- 10.1.3. Estimating real default probabilities -- historical data -- 10.1.4. Estimating real default probabilities -- equity-based approaches -- 10.1.5. Estimating risk-neutral default probabilities -- 10.1.6. Comparison between real and risk-neutral default probabilities -- 10.1.7. Recovery rates -- 10.2. Credit default swaps -- 10.2.1. Basics of CDSs -- 10.2.2. Credit events -- 10.2.3. CDS settlement -- 10.2.4. The CDS -- bond basis
-- 10.2.5. Contingent credit default swaps -- 10.3. Curve mapping -- 10.3.1. Basics of mapping -- 10.3.2. Indices and classification -- 10.3.3. Curve shape -- 10.4. Portfolio credit derivatives -- 10.4.1. CDS index products -- 10.4.2. Index tranches -- 10.4.3. Super senior risk -- 10.4.4. Collateralised debt obligations -- 10.5. Summary -- 11. Portfolio Counterparty Credit Risk -- 11.1. Introduction -- 11.2. Double default -- 11.2.1. Joint default events -- 11.2.2. Merton-style approach -- 11.2.3. Impact of correlation -- 11.3. Credit portfolio losses -- 11.3.1. Simple two-name example -- 11.3.2. Loss distributions and unexpected loss -- 11.3.3. Example -- 11.3.4. The alpha factor -- 11.3.5. Alpha and wrong-way risk -- 11.4. Summary -- 12. Credit Value Adjustment -- 12.1. Definition of CVA -- 12.1.1. Why pricing CVA is not easy -- 12.1.2. CVA formula -- 12.1.3. CVA as a spread -- 12.2. CVA and exposure -- 12.2.1. Exposure and discounting -- 12.2.2. Risk-neutral exposure -- 12.2.3. CVA semi-analytical methods -- 12.3. Impact of default probability and recovery -- 12.3.1. Credit spread impact
Note continued: 12.3.2. Recovery impact -- 12.4. Pricing new trades using CVA -- 12.4.1. Netting and incremental CVA -- 12.4.2. Marginal CVA -- 12.4.3. CVA as a spread -- 12.4.4. Numerical issues -- 12.4.5. Path dependency, break clauses and exotics -- 12.5. CVA with collateral -- 12.5.1. Impact of margin period of risk -- 12.5.2. Threshold CSAs and independent amounts -- 12.6. Summary -- 13. Debt Value Adjustment -- 13.1. DVA and counterparty risk -- 13.1.1. The need for DVA -- 13.1.2. Bilateral CVA -- 13.1.3. Examples of BCVA -- 13.1.4. Impact of collateral -- 13.1.5. Properties of DVA -- 13.2. The DVA controversy -- 13.2.1. Liability measurement and accounting standards -- 13.3. How to monetise DVA -- 13.3.1. File for bankruptcy -- 13.3.2. Unwinds and novations -- 13.3.3. Closeout -- 13.3.4. Hedging -- 13.3.5. Funding -- 13.4. Further DVA considerations -- 13.4.1. Impact of default correlation -- 13.4.2. DVA and closeout -- 13.5. Summary -- 14. Funding and Valuation -- 14.1. Background -- 14.2. OIS discounting -- 14.2.1. The impact of CSAs -- 14.2.2. OIS and LIBOR rates -- 14.2.3. CSA optionality -- 14.2.4. Central counterparties -- 14.2.5. Methodology -- 14.3. Funding value adjustment -- 14.3.1. The need for FVA -- 14.3.2. The source of funding costs -- 14.3.3. DVA formula -- 14.3.4. Defining the funding rate -- 14.3.5. Examples -- 14.3.6. FVA and DVA -- 14.3.7. The impact of collateral -- 14.4. Optimisation of CVA, DVA and funding costs -- 14.4.1. The spectrum of trading with BCVA and FVA -- 14.4.2. The impact of CSAs -- 14.4.3. Central clearing -- 14.4.4. Optimisation and impact of regulatory capital -- 14.5. Future trends -- 14.5.1. Standard CSA -- 14.5.2. The conversion of CVA into funding liquidity risk -- 14.6. Summary -- 15. Wrong-Way Risk -- 15.1. Introduction -- 15.2. Overview of wrong-way risk -- 15.2.1. Simple example -- 15.2.2. Classic example and empirical evidence -- 15.2.3. Right-way risk and hedging -- 15.2.4. Wrong-way risk challenges -- 15.2.5. Wrong-way risk and CVA -- 15.2.6. Simple example -- 15.3. Portfolio wrong-way risk -- 15.3.1. Correlation approach -- 15.3.2. Parametric approach -- 15.3.3. Calibration issues -- 15.3.4. DVA and wrong-way risk -- 15.4. Trade-level wrong-way risk -- 15.4.1. Interest rates -- 15.4.2. Foreign exchange example -- 15.4.3. Risky option position -- 15.4.4. Commodities -- 15.4.5. Contingent CDS -- 15.4.6. Wrong-way risk and collateral -- 15.5. Wrong-way risk and credit derivatives -- 15.5.1. Single-name credit derivatives -- 15.5.2. Credit derivative indices and tranches -- 15.5.3. The failure of CDOs -- 15.5.4. Central clearing and wrong-way risk -- 15.6. Summary -- SECTION IV MANAGING COUNTERPARTY CREDIT RISK -- 16. Hedging Counterparty Risk -- 16.1. Background to CVA hedging -- 16.1.1. Aim of CVA hedging -- 16.1.2. CVA as an exotic option -- 16.1.3. Risk-neutral or real-world? -- 16.1.4. Traditional hedging of fixed exposures -- 16.2. Components of CVA hedging -- 16.2.1. Single-name CDS -- 16.2.2. Contingent CDS -- 16.2.3. CVA Greeks -- 16.3. Exposure hedges -- 16.3.1. Spot/forward rates -- 16.3.2. Drift and hedging -- 16.3.3. Volatility -- 16.4. Credit hedges -- 16.4.1. Credit delta -- 16.4.2. Gamma and jump-to-default risk -- 16.4.3. Credit hedging with indices -- 16.4.4. Recovery rate sensitivity -- 16.5. Cross-dependency -- 16.5.1. Re-hedging costs -- 16.5.2. Cross-gamma -- 16.5.3. Hedging wrong-way risk -- 16.5.4. Unintended consequences of CVA hedging -- 16.5.5. Index CCDSs -- 16.6. The impact of DVA and collateral -- 16.6.1. Hedging bilateral counterparty risk -- 16.6.2. DVA and index hedging -- 16.6.3. Impact of collateral on hedging -- 16.6.4. Aggregation of sensitivities -- 16.7. Summary -- 17. Regulation and Capital Requirements -- 17.1. Introduction -- 17.2. Basel II -- 17.2.1. Background -- 17.2.2. General approach to credit risk -- 17.2.3. Asset correlation and maturity adjustment factor -- 17.3. Exposure under Basel II -- 17.3.1. Current exposure method -- 17.3.2. Standardised method -- 17.3.3. Treatment of repo-style transactions -- 17.3.4. Internal model method -- 17.3.5. Exposure at default and alpha -- 17.3.6. Collateral under the IMM -- 17.3.7. Double default -- 17.4. Basel III -- 17.4.1. Basel III, counterparty credit risk and CVA -- 17.4.2. Stressed EPE -- 17.4.3. Backtesting -- 17.4.4. CVA capital charge -- 17.4.5. CVA VAR -- advanced approach -- 17.4.6. CVA VAR -- standardised approach -- 17.4.7. CVA VAR example -- 17.4.8. Shortcomings and criticisms of CVA VAR -- 17.4.9. Other relevant changes -- 17.5. Central counterparties -- 17.5.1. Trade- and default fund-related exposures -- 17.5.2. Calculation of the hypothetical capital -- 17.5.3. Calculation of aggregate capital requirements -- 17.5.4. Allocation of aggregate capital to clearing members -- 17.6. Summary -- 18. Managing CVA -- The CVA Desk -- 18.1. Introduction -- 18.2. The role of a CVA desk -- 18.2.1. Motivation -- 18.2.2. Mechanics of pricing -- 18.2.3. Mandate and organisational aspects -- 18.2.4. Centralised or decentralised? -- 18.2.5. Coverage -- 18.2.6. Profit centre or utility? -- 18.3. CVA charging -- 18.3.1. Lookup tables -- 18.3.2. Product-specific pricing -- 18.3.3. Full simulation-based pricing -- 18.3.4. Unwinds, exercises, terminations and other special cases -- 18.3.5. Reducing CVA charges -- 18.3.6. Treatment of DVA -- 18.4. Technology -- 18.4.1. PFE vs CVA -- 18.4.2. Building blocks -- 18.4.3. Wrong-way risk -- 18.4.4. Intraday calculations -- 18.5. Practical hedging of CVA -- 18.5.1. To hedge or not -- 18.5.2. Actuarial approach -- 18.5.3. Market approach -- 18.5.4. DVA treatment -- 18.5.5. PnL explain -- 18.5.6. Securitisation -- 18.5.7. Pragmatic approach to hedging -- 18.6. Summary -- 19. The Future of Counterparty Risk -- 19.1. Key components -- 19.1.1. Regulatory capital and regulation -- 19.1.2. Collateral -- 19.1.3. CVA hedging -- 19.1.4. The credit derivative market -- 19.1.5. Central clearing -- 19.1.6. Too big to fail -- 19.2. Key axes of development -- 19.2.1. Quantification -- 19.2.2. Infrastructure -- 19.2.3. Risk mitigation -- 19.2.4. DVA -- 19.2.5. Wrong-way risk -- 19.2.6. Links to valuation and funding costs -- 19.2.7. Risk transfer -- 19.3. The continuing challenge for global financial markets.
Revised edition of: Counterparty credit risk. c2010.
Includes bibliographical references (pages 435-441) and index.
Includes bibliographical references and index.