Credit Valuation Adjustment

Implementation of CVA

PRMIA Credit Valuation Adjustment (CVA) CONGRESS IMPLEMENTATION UND PRAXIS

Wolfgang Putschgl
Kln, 20th July 2011

CVA in a nutshell

Usually pricing of derivatives does not take the possibility of default into account
Exposure E

E.g. Value of Option V(t,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) = V(t,T) CVA (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

recovery rate of counterpart

probability of default of the counterpart time of default

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, 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. Computation of relevant risk figures/Metrics (Exposure measures, CVA, )

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

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, 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. and maint. Scenario Generation Intraday checks

7 8 9

2
Position Revaluation

Exposure Measurement c/p Mgt, review and aggr. 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; REPOSITORY; AUDIT CHECKS; )

1
Risk factor scenario are used to get possible evolution of exposures. The same framework can be used for both regulatory purposes (EoD) and intraday trading needs. Based on the risk factor scenarios, a full repricing of the portfolio is needed at each future time grid point until the last expiry date.

Market data acquisition and validation Unobservable market data computations (correlations, 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)

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),

3 Once the value of each trade in the portfolio is

known until maturity, mark to futures must be aggregated according to the available legal agreements (netting/collateral) in order to get the exposures

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

Regulatory reporting Credit limits reports (PFE) Stress testing results and Wrong way risk Concentration risk (per issuer, country, )

CVA and CCR Functional Model

Pre-Deal Limit and CVA Check

Limits Exceptions

Incremental Credit Exposure, CVA

Scenario Generator (support for risk neutral (CVA) and historic (Limit) scenarios)
Current Market Data

Product Eligibility, Limits

Limit/CVA Manager, Exception Manager

P&L Vectors, Sensitivities

Revaluation Engines
Trade and Positions

Aggregation Engine
Exposure CVA, CVA Sensitivities, CVA Charge RWA Credit Hierarchies Counterparty Data, PDs Netting Agreements Collateral Balances

Results Data (Exposure, CVA,RWA)

Counterparty Data

Legal, Netting Agreements

Trade and Position Data

Adjustments

Client Onboarding

Internal and Regulatory Reporting

Legal Agreements

Stress Test, Back Testing

CSAs

Collateral Management

Controls and Adjustments

Trade Data, EOD and Intra Day

Trading Risk and Valuation Data Controls

Fixed Income (Rates, Credit)

Equities

FX and Money Market

Repos and Lending

Market Data

Pre-deal limit check, trade approval, CVA Charge Market 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

Implementing CVA - practical considerations

Active approach vs. 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. buy) Data challenges Define relevant data necessary to calculate and aggregate CVA Business processes

Forthcoming regulatory requirements

Implementing CVA - practical considerationscontd

Methodology Unilateral vs. bilateral Risk neutral scenarios for exposure calculation blend of market implied and historic market data Modelling of probabilities of default historic vs. risk neutral choice of mapping approach Client segmentation observability of clients (liquid vs. illiquid c/p) Wrong way risk design and implementation Gap risk (for CSAs)

Implementing CVA - practical considerationscontd

Credit Mapping - Example
CDS
Region Client Type

Index Name

Sector
Financials, Govt, Basic Materials, Consumer Goods, Consumer Services, Health Care, Industrials, Oil & Gas, Technology, Telecoms, Utilities

Rating

Invest. 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

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, derivatives,), EPE (Underlying risks on the derivatives): trade instruments relevant for hedging e.g. interest rate swaps, fx forwards, volatility 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), 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
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