Interrelations Amongst Liquidity, Market and Credit Risks

Balance Sheet Items Requiring Statistic-Financial Models
Liquidity and Counterparty Risks
Interrelations amongst Liquidity, Market and

Credit Risks
some proposals for integrated approaches
Antonio Castagna
www.iasonltd.com
28th February 2012
Risk - Managing Liquidity Risk under Basel III - London
Antonio Castagna - Iason 2012 - All rights reserved

Index

Deposits
Prepayment of Fixed Rate Mortgages
Credit Lines

Introduction
Liquidity Risk Pricing in OTC Derivatives
Haircut Setting

Deposits
Credit Lines
Index

Deposits
Credit Lines

Introduction
Haircut Setting

Deposits
Credit Lines
Index

Deposits
Credit Lines

Introduction
Haircut Setting

Deposits
Credit Lines
The Relevance of Deposits in the Banking Activity

Non-maturing deposits represent a significant source of funding for a financial
institution. Yet, there is still no commonly accepted framework for valuation
and for interest rate and liquidity risk management.
Such a framework is needed even more in the current environment:
non-maturing deposits are a low-cost source of funding, compared with
other sources, so that in a funding-mix they contribute to abate the total
cost of funding (although a consistent model is needed to manage them,
such as the one proposed by Iason);
the interest rate and the liquidity risks have to be properly identified,
measured and hedged, in order to make possible the insertion of the
deposits volumes in the funding management;
liquidity crisis have to be modelled, allowing for stress-testing activity
involving both idiosyncratic and market specific extreme scenarios.

Deposits
Credit Lines
Overview of the Proposed Model

We assume that the bank offers different deposits, i.e.: transaction
account and different savings accounts.
A transaction account is mainly used by the customer to fulfill his short
term liquidity needs while he uses the savings accounts as investment
opportunities with very small risk.
The framework models three factors:
market rates,
deposits rates
deposits volumes.
These factors determine the customer behaviour, modelled as reasonable
rules or strategies to set the total level of deposits, and then the
allocation amongst the different types of deposits.
Once this is done, we can calculate the value of the deposits, their
sensitivities to market rates and the amounts available, thus allowing for
the design of hedging and liquidity management strategies.

Deposits
Credit Lines
Market Rates
We can use any available model for market rates. We choose an extended Cox,
Ingersoll and Ross model (CIR), with a time dependent deterministic shift
parameter (to perfectly match the starting term structure of market rates). The
instantaneous rate r (t) is defined as
r (t) = x(t) + (t)
where x(t) has a CIR dynamics:
dxt = [ xt ]dt + xt dZt

and (t) is a deterministic function of time.
Term Structure
An example of curves generated with:

x0 = 2%, = 0.5, = 4.5%, =
7.90%, (t) = 0 for any t
Zero-rate curves and implied 6 month
forward rates are shown in the picture.
5.00%
4.50%
4.00%
3.50%
3.00%
Zero
2.50%
6M
2.00%
1.50%
1.00%
0.50%
0.00%
1
10 11 12 13 14 15 16 17 18 19 20

Deposits
Credit Lines
Deposit Rates
We assume that deposit rates are a function of the (short term) market interest
rates and volumes:
dn (t) = d(r (t), V (t))
where dn is the rate for the deposit of type n, r (t) is the instantaneous rate
and V (t) is the amount deposited. The function is given by the banks pricing
policy.
Examples may be:
constant spread below market rates:
dn (t) = max[r (t) , 0]
a proportion of market rates:
dn (t) = r (t)
a function as the two above dependent on the amount deposited
dn (t) =
m
X
dj (r (t))1{vj ,vj+1 } (V (t))
j=1
where vj and vj+1 are ranges of the volume V producing different levels of
the deposits rate.

Deposits
Credit Lines
Deposits Volumes
We make the following assumptions to model the customers behaviour
determining the deposits volumes:
A customer modifies his balance on the transaction account targeting a
given fraction of its average monthly income. This level can be interpreted
as the amount he needs to cover his short time liquidity needs.
There is an interest rates strike level, specific for the customer, such that,
when the market rate is above it, then the customer reconsiders the target
level and redirects a higher amounts to other investments.
A customer has a savings account policy targeting to save a fraction of
his income.
Again, there is a strike level, specific for the customer, such that when the
market rate is above it then the customer increases the fraction saved.
A customer may reconsider his savings policy and may decide to close one
or more of his savings accounts. If he takes such actions he reallocates all
of his money to one of the other savings accounts offered by the bank.

Deposits
Credit Lines
Deposits Volumes
On an aggregate basis, we consider the average customer to model the total
deposits volume.
To take into account the degree of heterogeneity among the customers,
concerning the level of the market rate at which the customer changes his
policy for the transaction account and for the total savings volume, we adopt a
Gamma distribution:
(x/)1 exp(x/)
()
40
35
30
25
Disitribution 1
20
Distribution 2
15
10
5
0.37
0.35
0.33
0.31
0.29
0.27
0.25
0.2
0.24
0.22
0.18
0.16
0.1
0.14
0.12
0.08
0.06
0.04
0
0.02
The Gamma function is very flexible.

If we, for example, set = 1.5 and
= 0.05 we have a distribution labeled
as 1 in the figure. If = 30 and
= 0.002 we have a distribution 2.
It is possible to model the aggregated
customers behaviour, making it more or
less concentrated around specific levels.

Deposits
Credit Lines
Evolution of Deposits Volumes: Second Example
10.00%
9.00%
8.00%
7.00%
6.00%
5.00%
4.00%
3.00%
2.00%
1.00%
0.00%
Ref. rate
T rans. Depo
Savings2
00
10
.
9.1
8.3
7.5
6.6
5.
8
5.0
4.1
3.3
2.5
0.8
1.
6
Savings2
7000.0
6800.0
6600.0
6400.0
6200.0
T rans. Depo
6000.0
5800.0
00
10
.
3
8.3
9.1
7.5
6.6
5.
8
5.0
4.1
0
2.5
3.3
1.6
0.8
5600.0
5400.0
140000.0
120000.0
100000.0
Savings T ot
80000.0
Savings1
60000.0
Savings2
40000.0
20000.0
00
10
.
3
8.3
9.1
7.5
3
5.8
6.6
7
4.1
5.0
0
2.
5
3.3
1.6
0.0
0.8
We present the market and deposits interests rates, the evolution of the volumes of the transaction account, of the
total volume of the savings accounts and
the split between the savings 1 and
savings 2 accounts, in a different economic cycle.
At the beginning market rates are stable,
then they sharply increase. The transaction volume experiences a decline due to
the reallocation of the total savings in
other investments, since they offer higher
returns.
Also the composition of the total savings
account volume shows that the savings
2 account (yielding higher rates) is preferred to the savings 1 account.

Deposits
Credit Lines
Liquidity Risk
The behavioural modelling of the amounts of the different deposits allows us to
manage the liquidity risk, which is based on the concept of the term structure
of liquidity.
Generate a number S of scenarios.
For each 0 t T define the process of minima by:
Mj (t) = min V (s)
0st
In each scenario the stochastic process Mj (t) specifies the minimal volume
between [0, t]. This is the amount available for investment over the entire
period in the given scenario.
Define Lts (t, q) as the p-quantile of Mj (t). The probability that the
volume V drops below level Lts (t, q) in the time interval [0, t] is q.
Lts (t, q) is the amount available for investment with probability q. We
name it Term Structure of Liquidity.
The Term Structure of Liquidity can therefore be used to implement
liquidity policies.

Deposits
Credit Lines
Liquidity Risk: a Practical Example

Time
1
2
3
4
5
6
7
8
9
10
The table indicates the Term Structure

of Liquidity up to 10 years for transaction
deposits, given the assumptions stated
above, with a probability of 99%.
The Term Structure of Liquidity up to 10

years for the transaction deposits is also
shown in the figure.
6500.00
6400.00
6300.00
6200.00
6100.00
6000.00
5900.00
5800.00
5700.00
5600.00
5500.00
5400.00
Trans. Depo
Amnt
5905
5808
5796
5798
5856
5919
6053
6151
6325
6430
10

Deposits
Credit Lines
Liquidity Risk: a Practical Example
We now show in the table the Term

Structure of Liquidity for the two types
of savings deposits, given the assumptions stated above, with a probability of
99%.
Time
1
2
3
4
5
6
7
8
9
10
Amnt Sav 1
47657
47087
47301
47305
47810
47990
48743
48979
48496
48572
Amnt Sav 2
50882
52014
53214
54372
56232
57455
59620
61043
62477
63865
70000.0
Also for savings deposits, a visual representation of the Term Structure of Liquidity is also produced.
60000.0
50000.0
40000.0
Savings1
30000.0
Savings2
20000.0
10000.0
0.0
1
10

Deposits
Credit Lines
Valuation of Deposits
The value of the deposits is different from their amount. It is possible to show
that the value to the bank, assuming that volumes are deposited up to time T ,
is:
n Z T
X
E Q [r (t) dj (t)Vj (t)P(0, t)]dt
V(0, T ) = N
j=1
where:
N is the number of average customers;
n is the number of types of deposits;
Vj (t) and dj (t) are, respectively, the amount and the rate for deposit j at
time t;
P(0, t) is the price, at time 0, of a pure discount bond expiring in T .
The value of the deposits can be considered as the value of an exotic swap,
paying the floating rate dj (t) and receiving the floating rate r (t), on the
stochastic principal Vj (t), for the period between 0 and t.

Deposits
Credit Lines
Valuation and Interest Rate Risk: a Practical Example
The table shows the value V(0, T ) at

time 0 of the transaction deposits. We
assume we have 10 swap contract, expiring from 1 year to 10 years, as hedging insturments. We identify 10 scenarios
where each swap rate is tilted up 10 bps.
The table also shows the values corresponding to 10 scenarios and the sensitivities to each swap rate. Since we limited our time horizon to 10 years, the
bulk of the exposure is to the 10-year
swap, all other sensitivity being negligible.
0
1
2
3
4
5
6
7
8
9
10
Value
1994.057
1994.058
1994.052
1994.044
1994.033
1994.023
1994.013
1994.002
1993.977
1993.911
1998.343
Sens +10bps
0.00
- 0.01
- 0.01
- 0.02
- 0.03
- 0.04
- 0.06
- 0.08
- 0.15
4.29

Deposits
Credit Lines
Adding the Risk of Bank Run

The framework can be extended so as to include a possible bank run causing a
sudden drop in the deposits volumes. This is useful to compute a Liquidity
VaR and to operate stress-testing. To that end:
we assume that customers may loose confidence in the financial
institution, so that they withdraw in a very short time a large percentage
of the deposited volumes;
we use as an indicator of the confidence the CDS spread (or a similar
spread extracted from bonds issued by the bank), which is modelled by a
CIR dynamics, similarly to the instantaneous interest rate;
the bank run is triggered by a high level of the spread, indicating a high
perceived default probability of the bank;
the heterogeneity in the customers behaviour is modelled by a Gamma
distribution, as for the behaviour determining the allocation amongst
deposits and other investments.

Deposits
Credit Lines
Risk of Bank Run: a Practical Example
8.00%
7.00%
6.00%
5.00%
4.00%
CDS spread
3.00%
2.00%
00
10
.
3
8.3
9.1
7
6.6
7.5
0
5.0
5.8
3
3.3
4.1
0.8
1.6
2.5
1.00%
0.00%
7000.0
6000.0
5000.0
4000.0
T rans. Depo
3000.0
2000.0
1000.0
00
10
.
3
8.3
9.1
7.5
6.6
5.
8
5.0
4.1
3.3
2.5
7
1.6
0.8
0.0
120000.0
100000.0
80000.0
Saving T ot
60000.0
Savings1
40000.0
Savings2
20000.0
00
10
.
3
8.3
9.1
3
5.8
7.5
6.6
7
4.1
5.0
3
3.3
2.5
1.6
0.0
0.8
The figure plots the evolution of the instantaneous zero-spread, assuming a CIR
dynamics for the default intensity and a
recovery rate of 40% of the face value
on default.
The trigger rate has been placed in a narrow range around 800 bps of the CDS
spread; we assume customers withdraw
85% of the deposited volumes in case
they loose confidence in the bank. The
transaction deposits experience a sudden
drop in volumes as the spread climbs towards the trigger level.
We make a similar assumption of withdrawal for the savings accounts. Also
their volumes quickly decreases in a
bank run scenario.

Deposits
Credit Lines
Index

Deposits
Credit Lines

Introduction
Haircut Setting

Deposits
Credit Lines
Facts about Prepayments

Empirical features commonly attributed to mortgage prepayment include:
some mortgages are prepaid even when their coupon rate is below current
mortgage rates;
some mortgages are not prepaid even when their coupon rate is above
current mortgage rates.
prepayment appears to be dependent on a burnout factor.
The model we propose takes into account these features:
mortgagees decide whether to prepay their mortgage at random discrete
intervals. The probability of a prepayment decision taken on interest rate
reasons, is commanded by a hazard function : the probability that the
decision is made in a time interval of length dt is approximately dt;
besides refinancing for interest rate reasons, the mortgagees may also
prepay for exogenous reasons (e.g.: job relocation, or sale of the house).
The probability of exogenous prepayment is described by a hazard function
: this represents a baseline prepayment level, the expected prepayment
level when no optimal (interest-driven) prepayment should occur.

Deposits
Credit Lines
The Probability of Prepayment

We model the interest rate based prepayment within a reduced form approach.
This allows us to include consistently the prepayments into the pricing, the
interest rate risk management (ALM) and the liquidity management.
We adopt a stochastic intensity of prepayment , assumed to follow a CIR
dynamics:
dt = [ t ]dt + t t dZt
the intensity is common to all obligors and provides the probability that
the mortgage rationally terminates over time;
the intensity is correlated to the interest rates, so that when rates move to
lower levels, more rational prepayments occur;
the framework is stochastic and it allows for a rich specification of the
prepayment behaviour;
The exogenous prepayment is also modelled in a reduced form fashion, by a
constant intensity .

Deposits
Credit Lines
The Probability of Prepayment

Consider a mortgage with coupon rate c expiring at time T :
each period, given the current interest rates, the optimal prepayment
strategy determines whether the mortgage holder should refinance;
for a given coupon rate c, considering also transaction costs, there is a
critical interest rates level r such that if rates are lower (rt < r ) then
the mortgagor will optimally decide to prepay;
if it is not optimal to refinance, any prepayment is for exogenous reasons;
if it is optimal to refinance, the mortgagor may prepay either for interest
rate related or for exogenous reasons.
These considerations lead to the following prepayment probability:
R

T
PP(t, T ) = 1 e (T t) E e t s ds if rt < r
PP(t, T ) = 1 e (T t) if rt > r
(1)
(2)

Deposits
Credit Lines
Prepayment Probability Curves: An Example
The figure plots the prepayment probabilities for different times up to the (fixed
rate) mortgages expiry, assumed to be in
10 years. The three curves refer to:
the exogenous prepayment, given
by a constant intensity = 3.5%;
the rational (interest driven)
prepayment, produced assuming
0 = 10.0%, = 27%, =
50.0% = 10.0%.
the total prepayment when it is
rational to prepay the mortgage
(rt < r ).
90.00%
80.00%
70.00%
60.00%
50.00%
Exogenous
Rational
Total
40.00%
30.00%
20.00%
10.00%
0.00%
1
10

Deposits
Credit Lines
Modelling Losses upon Prepayment

It is possible to compute the Expected Loss on Prepayment, defined as
the Expected Loss at a time tk given that the decision to prepay (for
whatever reason) is taken between tk1 and tk :

X
P(tk , tj )j Aj1 (c c ); 0 .
ELoP(tk ) = E PP(tk1 , tk ) max
j
the computation of the ELoP is unfortunately not possible in a closed

form formula: this can be a problem since the ELoP has to be computed
for all the possible exercise dates for a mortgage, and this for a likely large
number of mortgages;
considering the fact that we are interested also in the computation of the
sensitivities of the ELoP, for hedging purposes, the computation via
numerical techniques, such as Montecarlo, can be very time-consuming
and unfeasible;
for this reason we developed an analytical approximation to model:
the future fair mortgage rate c,
the correlation between the fair rate c and the rational prepayment
intensity t ;
Deposits
Credit Lines

Modelling Losses upon Prepayment

We are now able to measure which is the expected loss occurring to the
bank upon prepayment, at each possible prepayment date tk ;
We define the current value, at time t0 , of all the expected losses is the
Total Prepayment Cost (TPC) related to a mortgage:
X
TPC(t0 ) =
P(t0 , tk )ELoP(tk )
k
the TPC is the quantity to be hedged. It is a function of:

the Libor forward rates,
the volatilities of the Libor forward rates,
the stochastic rational prepayment intensity t and constant
exogenous intensity ;
the TPC can be also included in the mortgage pricing when calculating
the fair rate c.

Deposits
Credit Lines
Hedging Prepayment Exposures
The model allows also to compute sensitivities to the main underlying risk
factors:
sensitivity to Libor rates can be computed by tilting each forward a given
amount (e.g.: 10 bps), and then recomputing the TPC;
Libor exposures can be translated to swap rates exposures, since these are
the most liquid and easily tradable hedging tools;
by the same token, we can compute also the sensitivities to Libor
volatilities: these exposures can be hedged by trading caps&floors;
the sensitivity to the prepayment, both rational and exogenous, can be
derived, but no market instrument exists to hedge this exposure. In this
case, a VAR-like approach can be adopted and the unexpected cost
included into the fair rate, or economic capital posted to cover this risk.

Deposits
Credit Lines
A Practical Example
Assume 1Y Libor forward rates and their
volatilities are those in the table besides.
Assume also that the exogenous prepayment intensity is 3% p.a. and the rational
prepayment intensity has the same dynamics parameters as presented above.
We consider a 10Y mortgage, with a

fixed rate paid annually of 3.95%. The
fair rate has been computed wihout taking into account any prepayment effect
(also credit risk is not considered, although it can be included within the
framework). The amortization schedule
is in the table besides.
Yrs
1
2
3
4
5
6
7
8
9
10
Fwd Libor
3.50%
3.75%
4.00%
4.25%
4.50%
4.75%
5.00%
5.25%
5.50%
5.75%
Yrs
1
2
3
4
5
6
7
8
9
10
Vol
18.03%
18.28%
18.53%
18.78%
18.43%
18.08%
17.73%
17.38%
17.03%
16.78%
Notional
100.00
90.00
80.00
70.00
60.00
50.00
40.00
30.00
20.00
10.00

Deposits
Credit Lines
A Practical Example: The EL and the ELoP.

Given the market and contract data
above, we can derive the EL at each possible prepayment date, which we assume
occurs annually. It is plotted in the figure. The closed form approximation has
been employed to compute the EL.
In a similar way it is possible to calculate
the ELoP. We use also in this case an
analytical approximation that allows for
a correlation between interest rates and
the rational prepayment intensity.
In the figure the ELoP is plotted for the
0 correlation case and for a negative correlation set at 0.8. This value implies
that when interest rates decline, the default intensity increases.
Since the loss for the bank is bigger when
the rates are low, the ELoP in this case
is higher than the uncorrelated case.
0.90000
0.80000
0.70000
0.60000
0.50000
Expected loss
0.40000
0.30000
0.20000
0.10000
1
0.0900
0.0800
0.0700
0.0600
0.0500
ELoP Zero Corr

ELoP Negative Corr
0.0400
0.0300
0.0200
0.0100

Deposits
Credit Lines
A Practical Example: Hedging the Prepayment Risk

The hedging of the prepayment risk (or,
of the TPC) is possible with respect to
the interest rates and to the Libor forward volatilities. The TPC is 48 bps.
The first table shows the sensitivity of
the TPC to a tilt of 10 bps for each
forward rate. Those sensitivities are then
translated in an equivalent quantity of
swaps, with an expiry form 1 year to 10
years, needed to hedge them.
The second table shows the Vega of the
TPC with respect to the volatilities of
each Libor forward rate. Those exposures
can hedged with caps&floors, or swaptions in the Libor Market Model setting
we are working in (by calibrating the Libor correlation matrix to the swaptions
volatility surface).
Yrs
1
2
3
4
5
6
7
8
9
Sensitivity
0.02
0.02
0.02
0.01
0.01
0.01
0.01
0.00
0.00
Yrs
1
2
3
4
5
6
7
8
9
Hedge Qty
16.82
9.07
5.58
3.45
2.19
1.38
0.92
0.64
0.40
Vega
0.08
0.20
0.33
0.45
0.53
0.54
0.48
0.33
0.12

Deposits
Credit Lines
Liquidity Management
We have shown how the framework can

be used to measure and hedge the prepayment risk in its form of replacement
cost.
The model can be also use to project expected cash flows due to the prepayment
activity.
Since the rational prepayment is stochastic and correlated to the level of the interest rate, a VaR-like approach can be
adopted also in this case to calculate the
maximum and minimum amount of cash
flows;
Expected
Cash Flows
22.34
20.96
17.59
14.15
11.28
9.13
7.56
6.39
5.48
Cash
Flows
13.95
13.56
13.16
12.77
12.37
11.98
11.58
11.19
10.79
Expected
Amort.
81.61
64.08
49.44
37.78
28.55
21.08
14.81
9.35
4.46
Amort.
90.00
80.00
70.00
60.00
50.00
40.00
30.00
20.00
10.00
100.00
90.00
80.00
70.00
60.00
Amort.
50.00
Exp. Amort.
40.00
30.00
20.00
10.00
0.00
1

Deposits
Credit Lines
Index

Deposits
Credit Lines

Introduction
Haircut Setting

Deposits
Credit Lines
Introduction
Loan commitments or credit lines are the most popular form of bank
lending representing a high percent of all commercial and industrial loans
by domestic banks.
Loan commitments allow firms to borrow in the future at terms specified
at the contracts inception.
The model we propose simple, analytically tractable approach that
incorporates the critical features of loan commitments observed in
practice:
random interest rates;
multiple withdrawals by the debtor;
impacts on the cost of liquidity to back-up the withdrawals;
interaction between the probability of default and level of usage of
the line.

Deposits
Credit Lines
The model
The bank has a portfolio of m different credit lines, each one with a given
expiry Ti (i = 1, 2, ..., m).
Each credit line can be drawn within the limit Li at any time t between
today (time 0) and its expiry.
We assume the there is a withdrawal intensity indicating which is the used
percentage of the total amount of the line Li at a given time t:
from each credit line i, the borrower can withdraw an integer
percentage of its nominal: 1%, 2%, . . . , 100%;
each withdrawal is modelled as a jump from a Poisson distribution
(one specific to each credit line). This distribution can not have more
than 100 jumps. As an example, a 3% withdrawal is equivalent for
the Poisson process to jump 3 times;
the withdrawal intensity i (t) determines the probability of the
jumps during the life of the credit line. This intensity is stochastic
(so we have a doubly stochastic Poisson process).

Deposits
Credit Lines
Stochastic Withdrawal Intensity

The stochastic intensity allows to model:
the documented correlation between the worsening of the
creditworthiness of the debtor and the higher usage of the amount Li
of the credit line;
the correlation between the probabilities of default of the debtors of
the m credit lines.
Both effects have a heavy impact on the single and joint distributions of
the usage of the credit lines.
The liquidity management at a portfolio level is enhanced, since the bank
can properly take into account the joint distribution
The correlation between debtors determines in a more precise fashion the
value of credit lines and the credit VaR, relying on a framework more
robust and consistent than simple credit conversion factors.

Deposits
Credit Lines
Stochastic Intensity
The stochastic withdrawal intensity i (t), for the i-th debtor, is a combination
of three terms:
i (t) = i (t)(i (t) + D
i (t))
A multiplicative factor i (t) of a deterministic function of time i (t),
which can be used to model the withdrawals of the credit line independent
from the default probability of the debtor.
A multiplicative factor i (t) of the stochastic default intensity D
i (t)
(default is modelled as a rare event occurring with this intensity).
We model the correlation between debtor by assuming that the default
intensity is the sum of two separate components:
I
C
D
i (t) = i (t) + pi (t)

Deposits
Credit Lines
An Example: Usage Distribution of a Single Credit Line
The credit line nominal is equal to

5 mln, the expiry is in 1 year.
2,
00
0,
00
0
2,
50
0,
00
0
3,
00
0,
00
0
3,
50
0,
00
0
4,
00
0,
00
0
4,
50
0,
00
0
5,
00
0,
00
0
0
1,
00
0,
00
0
1,
50
0,
00
The multiplying factor is also

constant and equal to = 1000.
Given this, we have an average
withdrawal intensity at time 0
equal to 1000 (2% + 2%) = 40
or 40% of the total amount of the
line (since each jump corresponds
to 1% of usage).
00
The deterministic intensity is

constant and equal to 2%.
0.05
0.045
0.04
0.035
0.03
0.025
0.02
0.015
0.01
0.005
0
50
0,
0
The default intensity parameters

are chosen so that the debtors
probability of default is about 2%
in 1 year, and it declines on
average in the future toward a
long term average of 1.5%.
The figure shows the usage distribution of

the credit line over a period of 1 year. The
total amount of the credit line is Euro 5
mln. The average usage is 2,058,433. We
added the 99%-percentile of this
distribution which has the following value:
4,050,000.

Deposits
Credit Lines
Joint Usage Distribution of a Several Credit Line
In the present framework, the correlation amongst different debtors play a

great role in determining the joint usage distribution.
The pi s coefficient weights the dependence of the default intensity on the
common factor, and then it is an indication of the correlation amongst
debtors.
The higher the correlation (i.e.: pi s), the larger th expected usage and the
99%-percentile unexpected usage.
Even if for different scenarios (created by different pi s), the expected
usage is equal for the single credit lines, the expected joint usage and the
percentile changes with the choice of pi .

Deposits
Credit Lines
An Example: Usage Distribution of Several Credit Lines

We choose 3 credit lines, 5 mln, each and
two opposite scenarios:
0.04
The default intensity starts at 2%

for each debtor in both scenarios,
but the correlation amongst the
probability of defaults and of
default events is very different:
almost perfect in the first case
and almost nil in the second.
0.03
0.025
0.02
0.015
0.01
0.005
00
00
16
,0
00
,0
14
,0
00
,0
00
00
00
,0
12
,0
10
,0
00
,0
8,
0
00
,0
00
00
00
00
,0
6,
0
4,
00
0,
0
00
00
,0
Second Scenario: we choose

pi = 0.001 and calibrate again
and the parameters of the default
intensity so as to have an
expected usage of 50%:
0.035
2,
0
First Scenario: we choose

pi = 0.999 and calibrate and the
parameters of the default intensity
so as to have an expected usage
of 50%:
The figure shows the joint usage

distribution, and the 99% precentile, for
first scenario (in red) and for the second
scenario (in blue). In both scenarios the
expected usage is almost 7.5 mln. The
99%-percentile usage is 14, 750, 000 in the
first scenario and 9, 150, 000 in the second
scenario.

Introduction
Haircut Setting
Index

Deposits
Credit Lines

Introduction
Haircut Setting

Introduction
Haircut Setting
Index

Deposits
Credit Lines

Introduction
Haircut Setting

Introduction
Haircut Setting
Credit Mitigation Agreements

Agreements between counterparties aim at limiting and reducing the
counterparty risk
1
Netting (e.g.: ISDA Master Agreement)
a contract that allows aggregation of transactions;
in the event of default of one of the counterparties, the entire
portfolio included in a netting agreement is considered as a single
trade.
2
Collateral Agreements (e.g.: ISDAs Credit Support Annex (CSA))
collateral is required if unsecured exposure is above a given threshold;
threshold and frequency depend on counterpartys credit quality.
3
Early termination clauses:
Termination clause: trade-level agreement that allows one (or both)
counterparties to terminate the trade at fair market value at a
predefined set of dates;
Downgrade provision: portfolio-level agreement that forces the
termination of the entire portfolio at fair market value the first time
the credit rating of one (or either) of the counterparties falls below a
predefined level.
4
Certain contracts, like Contingent CDS (CCDS).

Introduction
Haircut Setting
Collateral and Margin Agreements

Collateral agreement is a contract between two counterparties that
requires one or both counterparties to post collateral (typically cash or
high quality bonds) under certain conditions.
Margin agreement is a legally binding collateral agreement with specific
rules for posting collateral, which include:
1
Minimum transfer amount: defines the minimum amount of

collateral that can be exchanged. If the exposure entails a collateral
posting below the minimum, amount, no collateral is provided;
A threshold, defined for one (unilateral agreement) or both (bilateral
agreement) counterparties. If the difference between the net portfolio
value and already posted collateral exceeds the threshold, the
counterparty must provide collateral sufficient to cover this excess
(subject to minimum transfer amount);
Frequency: defines the periodicity of the exposure calculation and of
the determination of the collateral to post.
The terms of the rules depend mainly on the credit qualities of the
counterparties involved.

Introduction
Haircut Setting
Index

Deposits
Credit Lines

Introduction
Haircut Setting

Introduction
Haircut Setting
Pricing OTC Derivatives with CSA

In a very general fashion, the price at time 0 of a derivatives contract
which is not subject to counterparty risk is:
R

T
V0 = E Q e 0 rs ds VT
where
VT is the terminal pay-off of the contract;
rt is the (possibly time dependent) risk-free interest rate.
When counterpaty risk is considered, then we have to include the so called
CVA (the expected losses we suffer when on default of the counterparty)
the and DVA (the expected losses the counterparty suffers on our default):
R

T
V0CCP = E Q e 0 rs ds VT CVA + DVA
The terminal value of the contract is still discounted ad the risk-free rate
rt , but then the price is adjusted with the net effect due to the losses
upon default of the two counterparties involved in the trade.

Introduction
Haircut Setting

Assume now we have a CSA agreement operating between the two
counterparties. The CSA provides for a daily margining mechanism of the
full variation of the NPV (nowadays a very common form of the CSA).
The party that owns a positive balance on the collateral account
(corresponding to a positive NPV of the contract) pays the rate ct to the
other party.
The pricing of the contract can be now be operated by excluding the
default risk (there is still a very small residual risk between two daily
margining).
It can be shown that the pricing formula is very similar to the standard
case we have seen above, but with the collateral rate ct replacing the
risk-free rate rt .:
R

T
V0CSA = E Q e 0 cs ds VT
(3)

Introduction
Haircut Setting

This result is very convenient, since we have a well defined rate that has
to be paid on the collateral balance (set within the contract), whereas the
risk-free rate is very difficult to determine in the current market
environment (it used to be the Libor in the interbank market).
Usually the daily margined CSA agreements set the remuneration of the
collateral at the EONIA for contracts in euro (or some equivalent OIS rate
for other currencies). EONIA (OIS) rates can be considered the best
approximation of a risk-free rate.
Nevertheless there is still one assumption that is made when deriving the
pricing formula with the CSA:
The rate at which the bank can lend money is the same of the one it
can borrow money.
This assumption can be easily accepted when we price contracts whose
NPV can be replicated by a dynamic strategy.
When the NPV of the contract cannot be replicated (e.g.: forward and
swap contracts) then relaxing the assumption is trickier.
Introduction
Haircut Setting


Assume we have a contract whose value during the life of the contract at
any time 0 < t < T , Vt can be positive or negative.
We also assume that the bank can invest cash at a risk-free rate equal to
the collateral rate rt = ct , but it has a funding spread ft when borrowing
money over a short period, so that the total funding cost is rt + ft .
When considering the funding spread in the pricing of a collateralized
derivatives contract, it can be shown that the valuation equation can be
written as:
R

R

T
T
V0CSA = E Q e 0 cu fu 1{Vu <0} du VT = E Q e 0 cu du VT + FVA
(4)
where
FVA = E Q
Z
Rs
0 cu du
min(Vs (0), 0)fs ds
(5)

Introduction
Haircut Setting
A Practical Example
We show an example, assuming the following market data for interest rates:
Time
0
0.5
1
1.5
2
2.5
3
3.5
4
4.5
5
5.5
6
6.5
7
7.5
8
8.5
9
9.5
10
Eonia Fwd
0.75%
0.75%
1.75%
2.00%
2.25%
2.37%
2.50%
2.65%
2.75%
2.87%
3.00%
3.10%
3.20%
3.30%
3.40%
3.50%
3.60%
3.67%
3.75%
3.82%
3.90%
Spread
0.65%
0.64%
0.64%
0.63%
0.63%
0.62%
0.61%
0.61%
0.60%
0.60%
0.59%
0.59%
0.58%
0.58%
0.57%
0.57%
0.56%
0.56%
0.55%
0.55%
0.54%
Fwd Libor
1.40%
1.39%
2.39%
2.63%
2.88%
2.99%
3.11%
3.26%
3.35%
3.47%
3.59%
3.69%
3.78%
3.88%
3.97%
4.07%
4.16%
4.23%
4.30%
4.37%
4.44%
5.00%
4.50%
4.00%
3.50%
3.00%
Euribor Fw d
2.50%
Eonia Fw d
2.00%
1.50%
1.00%
0.50%
0.00%
0
1.5
2.5 3
3.5
4.5 5
5.5
6.5
7.5
8.5

Introduction
Haircut Setting
A Practical Example
Market data for caps&floors and swaptions volatilities are:
Caps&Floors
Expiry
Volatility
0.5
30.00%
1
40.00%
1.5
45.00%
2
40.00%
2.5
35.00%
3
32.00%
3.5
31.00%
4
30.00%
4.5
29.50%
5
29.00%
5.5
28.50%
6
28.00%
6.5
27.50%
7
27.00%
7.5
26.50%
8
26.00%
8.5
25.50%
9
25.50%
9.5
25.50%
10
25.50%
Expiry
0.5
1
1.5
2
2.5
3
3.5
4
4.5
5
5.5
6
6.5
7
7.5
8
8.5
9
9.5
10
Swaptions
Tenor
Volatility
9.5
27.95%
9
28.00%
8.5
27.69%
8
27.09%
7.5
26.61%
7
26.32%
6.5
26.16%
6
26.02%
5.5
25.90%
5
25.79%
4.5
25.68%
4
25.57%
3.5
25.46%
3
25.37%
2.5
25.28%
2
25.22%
1.5
25.21%
1
25.34%
0.5
25.50%
0

Introduction
Haircut Setting
A Practical Example: Collateralized Swap

We price under a CSA agreement a
receiver swap whereby we we pay the
Libor fixing semi-annually (set at the
previous payment date) and we receive the fixed rate annually. With
market data shown above, the fair
rate can be easily calculated (we are
using the new market standard approach to employ the EONIA/OIS
curve for discounting and the 6M Libor curve to project forward rates).
We assume also that we have to pay
a funding spread of 15bps over the
EONIA/OIS curve. This is applied to
the ENE plotted beside.
-0.0512%
3.3020%
3.3079%
0.0059%
FVA
Fair Swap rate
Swap Rate + Coll. Fund
Difference
ENE
0.5
1.5
2.5
3.5
4.5
5.5
6.5
7.5
8.5
9.5
(1.0000)
(2.0000)
(3.0000)
(4.0000)
(5.0000)
(6.0000)
(7.0000)

Introduction
Haircut Setting
A Practical Example: Collateralized Swap

We may be interested in calculating the impact of the liquidity of a
collateralized swap with respect to a
more conservative measure than the
ENE, similarly to what happens in
the counterparty risk management.
We choose the Potential Future Exposure, which is the expected negative NPV of the swap at a given level
of confidence, set in this example at
the 99% and computed with market
volatilities.
The funding spread is still 15bps over
the EONIA/OIS curve. The Potential
Future Exposure (blue line), and the
ENE (purple line, same as before) for
comparison, are plotted beside.
-0.2156%
3.3020%
3.3264%
0.0244%
FVA
Fair Swap rate
Swap Rate + Coll. Fund
Difference
0.5
1.5
2.5
3.5
4.5
5.5
6.5
7.5
8.5
9.5
(5.0000)
(10.0000)
(15.0000)
PFE
ENE
(20.0000)
(25.0000)
(30.0000)

Introduction
Haircut Setting
Index

Deposits
Credit Lines

Introduction
Haircut Setting

Introduction
Haircut Setting
Bonds as Collateral
Collateral can be also made of bonds, usually of good credit quality.
In this collateralization transforms counterparty credit risk into market risk
and issuers credit risk, which should be relatively small for the collateral
to be effective.
Even when the collateral itself can be defaultable (e.g.: in corporate
bonds or emerging currencies sovereign bonds) the counterparty credit risk
is strongly mitigated.
Common practices have appeared to manage the intrinsic risk of
collateral: marking to market and haircuts.
The problem is now to determine the fair level of the haircut on a bond,
given a chosen mark to market period.
We outline a simplified framework, with no mark-to market periods a
where the haircut can be set only once.
The approach can be extended to a portfolio of bonds posted as collateral,
but we will not pursue the analysis that further in the current discussion.

Introduction
Haircut Setting
A Framework to Set Haircuts

Assume that at time t a bank has a fixed exposure E to a given
counterparty.
The bank asks the counterparty for units of a bond expiring in Tb with
price B(t, Tb ) as collateral.
We assume that the time to maturity of the collateral is greater than the
expiration date of the contract, originating the exposure (e.g.: loan),
between the bank and the counterparty. The contract expiry is Ta
For the collateral pledged, there exists a haircut h.
Let us divide the interval [t, Ta ] in m periods of equal extension.
Assume now that our counterparty goes defaulted in tm , the end of one of
the m periods, in which case the bank has to recover the loss on the
exposure by selling the collateral bond in the market. Since the collateral
bond can go defaulted also, the loss the bank still suffers after the selling
is:
LGD(tm ) = E [B(tm , Tb )1B >tm + RB 1tm1 B tm ]
where B is the default time of the collateral bond and RB is its recovery
on default. We also assume that the default of the counterparty is
independent from the default of the bonds issuer.

Introduction
Haircut Setting

The expected loss can be computed by considering the PD of both the
counterparty and the bonds issuer.
We want to compute the maximum loss given a confidence level, say 99%,
if the counterparty goes defaulted.
We assume that the interest rates are modelled by a CIR model of the
kind:
dr = r (r r )dt + r r dZt
and the PD is produced by a stochastic intensity still with a CIR dynamics:
d = ( )dt + dWt
At the end of each period tm the minimum value of the bond is
determined after deriving the maximum level of the interest rate and of
the default intensity at the 99% c.l., given it is still alive in tm .
In case the collateral bond is in default, the recovery value must be
considered. The collateral value in tm is then the expected value in the
two states of the world.
Introduction
Haircut Setting


In the case we consider we have to set the level of the haircut once for all
at the beginning of the contract, so that we do not revise the quantity of
collateral bond after its market value changes.
Since counterpartys default can happen anytime during the period
between [t, Ta ], we will weight the possible values of the collateral bonds
at the several times ti by the probability of default between [tm1 , tm ] over
the total default probability over the entire contracts period:
wm =
PDC (tm1 , tm )
PDC (t, Ta )
The expected maximum loss over [t, Ta ] is
E LGD(tm ) =
m
X
i=1
E [B(ti , Tb )(1 PDB (t, ti ))
+ RB (PDB (t, ti1 ) PDB (t, ti ))]wm


Introduction
Haircut Setting
A Practical Example
Assume we have an exposer E originated
by a contract expiring in Ta = 6M and
the bank requires as collateral a bond
expiring in Tb = 10Y .
The term structure of the interest rates
and the PDs of the issuers are generated
by a CIR short rate and a CIR default intensity processes with the following parameters:
r0
r
r
r
1.00%
0.75
4.50%
25.00%
0.50%
0.75
1.00%
25.00%
Years
1
2
3
4
5
6
7
8
9
10
1Y Libor
2.05%
3.34%
3.91%
4.17%
4.28%
4.33%
4.35%
4.36%
4.36%
4.37%
PD
0.65%
1.47%
2.38%
3.33%
4.31%
5.30%
6.30%
7.31%
8.34%
9.37%

Introduction
Haircut Setting
A Practical Example
The collateral bond has the characteristics shown in the table below so that its
market price at time t0 is 100.4675.
We divide the contact period of 6
months in 6 monthly intervals and compute the minimum value of the bond at
the end of each period, considering also
the occurrence of default and the recovery. We weight these values as described
above so that we derive the quantity
capable to match the exposure, and
then we can set the haircut on the market value of the bond. The table beside
shows all calculations.
Face Value
Expiry
Coupon
Frequency
Recovery
100
10
4.50%
1
40%
Month
0
1
2
3
4
5
6
Month
0
1
2
3
4
5
6
PD
Cpt
0.00%
0.25%
0.52%
0.79%
1.07%
1.35%
1.64%
Min Coll
Value
100.47
97.99
96.69
95.53
94.33
93.49
92.95
Av. Coll.
Fair
Bond
Price
100.47
97.94
96.56
95.38
94.20
93.42
92.93
Recov.
0.00
0.04
0.13
0.15
0.13
0.08
0.02
Weight
Wed Coll
Value
15.49%
16.03%
16.51%
16.95%
17.34%
17.69%
Value
Haircut
15.18
15.50
15.77
15.99
16.21
16.44
95.08
1.05
5.66%

Introduction
Haircut Setting
About Iason
Iason is a company created by market practitioners, financial quants and programmers
with valuable experience achieved in dealing rooms of financial institutions.
Iason offers a unique blend of skills and expertise in the understanding of financial
markets, in the pricing of complex financial instruments and in the measuring and the
management of banking risks. The companys structure is very flexible and grants a
fully bespoke service to our Clients.
Iason believes that the ability to develop new quantitative finance approaches through
research as well as to apply those approaches in practice, is critical to innovation in risk
management and derivatives pricing. It brings into all the areas of the risk management
a new and fresh approach based on the balance between rigour and efficiency Iasons
people aimed at when working in the dealing rooms.
Besides tailor made services, Iason offers software applications to calculate and monitor
credit VaR and conterparty VaR, fund transfer pricing and loan pricing, liquidity-at-risk.
c
Iason
- 2012
This is a Iasons creation.
The ideas and the model frameworks described in this presentation are the fruit of the intellectual efforts and of the skills of the people
working in Iason. You may not reproduce or transmit any part of this document in any form or by any means, electronic or mechanical,
including photocopying and recording, for any purpose without the express written permission of Iason ltd.

Interrelations Amongst Liquidity, Market and Credit Risks

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Balance Sheet Items Requiring Statistic-Financial Models

Liquidity and Counterparty Risks