- Quantifi

Understanding trade profitability becomes critical with banks now pricing all the components of a trade including the model value using the appropriate discounting curve, the Credit Valuation Adjustment (CVA). the Cost of Regulatory Capital (CRC) and most recently the Funding Valuation Adjustment (FVA).

Accurately pricing CVA, CRC and FVA for a single trade requires taking into account all trades done with that counterparty, along with the collateral posted or received as part of any CSA. This presents new challenges for OTC businesses that have traditionally been siloed within banks. This challenge has driven a trend towards central measurement and management of these components by CVA desks with various strategies for allocating the P/L and risk of a trade between each trading desk and the CVA desk.

The FVA is the latest significant innovation in measuring trade profitability and captures the impact of funding and liquidity on the cost of a trade. This cost depends on the nature of the CSA (for example is the trade collateralised, uncollateralised, or one-way) and the net collateral posted or received.

To understand FVA we’ll look at both collateralised and uncollateralised swaps.

Should banks charge for FVA?

- Quantifi

Interest on the topic of Funding Valuation Adjustment (FVA ) was recently renewed, particularly in light of the JPMorgan’s (JPM) Q4 2013 earnings report on January 14th 2014, which for the first time included FVA.

JPM, during the investor presentation, explained the adoption of FVA. All of these points are consistent with the definition of FVA, which Quantifi presented in the previous articles. To recap, FVA arises when the bank has an unsecured trade with a counterparty and hedges it, via a secured trade, with a riskless counterparty. In which case if PV of the trade is positive, PV of the hedge is negative, and to cover margin/collateral call the bank has to borrow cash at its funding rate LIBOR+s where ‘s’ is a funding spread. The trade, and therefore funding, terminates if the bank or a counterparty defaults. FVA is the expected value of the funding cost. It can be expressed as expectation of the bank’s funding spread applied to positive PV (discounted to today) until deal maturity, or early termination due to bank or counterparty default.

Survey Reveals Banks Are Not Ready for Counterparty Risk Elements of Basel lll

- Quantifi and EY Survey

Enhancing counterparty credit risk management practices is a key focus for banks. This is in response to changes in accounting rules and new prudential and market regulations which have tightened substantially following the financial crisis. Collectively, these changes are having a deep impact on the market and have driven banks to invest significantly in better pricing and reporting capability and in the active management of counterparty credit risk.

“Regulatory mandates continue to drive change and will have a major impact on OTC businesses for most banks. Not only does it change the way in which banks address counterparty credit risk and credit value adjustment (CVA), it will also require them to undertake significant process and system changes,” comments Dmitry Pugachevsky, Director of Research, Quantifi. “New minimum capital ratios will drive new methods of measuring and allocating capital as banks will be required to hold more capital and higher quality of capital to cover CVA risk.”

- InteDelta

The measurement and management of counterparty risk is a rapidly evolving area. A range of new regulatory requirements is changing the way in which institutions view risk. This affects not only risk quantification but the whole commercial model of an institution. New regulations or risk measures can affect the commercial attractiveness of an institution’s existing product range or client profile. Against a backdrop of discipline in constant evolution, this whitepaper explores some of the key areas associated with the management and measurement of counterparty risk.

The Overhaul of Interest Rate Modelling

- TabbFORUM

A new generation of interest rate modelling is evolving, as an approach based on overnight indexed swap discounting and integrated credit valuation adjustment is becoming the market consensus.

Prior to the credit crisis, interest rate modelling was generally well understood. Credit and liquidity were ignored, as their effects were minimal. Pricing a single currency interest rate swap was straightforward: A single interest rate curve was calibrated to liquid market products, and future cash flows were estimated and discounted using this single curve.

Today, a new interest rate modelling framework is evolving based on overnight indexed swap, or OIS, discounting and integrated credit valuation adjustment (CVA). Pricing a single currency interest rate swap now takes into account the difference between projected rates such as Euribor that include credit risk and the rates appropriate for discounting cash flows that are risk-free or based on funding cost. This approach is referred to as OIS discounting. In addition, the counterparty credit risk of (uncollateralized) OTC transactions is measured as a CVA.

Authored by Rohan Douglas, Quantifi

Maximizing Collateral Advantage: A Survey of Buy Side Business and Operational Strategies

- Celent

Abstract

It will cost the financial industry in excess of $53 billion in infrastructure and technology investments to upgrade and source new capabilities to achieve collateral efficiency and operational efficiency in a mixed clearing and collateralization environment.

In this report, based on a survey by Celent and commissioned by Omgeo, Maximizing Collateral Advantage: A Survey of Buy Side Business and Operational Strategies, Celent examines the state of buy side collateral management capabilities to understand how senior executives, practitioners, and industry experts from asset managers, hedge funds, insurance asset management units, and pension funds envisage the future of their collateral operations/IT, and how their organizations are formulating strategies towards their goals.

Firms are likely to be impacted in the way they hedge and trade derivatives; more than half of institutional investors surveyed stated that market reforms would materially change their trading behavior and asset allocation activities.

Authored by Cubillas Ding, Celent

Quantifi and Risk Dynamics Whitepaper — Optimising Capital Requirements for Counterparty Credit Risk

- Risk Dynamics

This paper explores how to deal with counterparty credit risk in the current financial environment by detailing some of the associated aspects and challenges. It also studies the conditions for effective management of counterparty credit risk. In a joint effort, Quantifi and Risk Dynamics compare capital requirements, identify inconsistencies in prudential regulations and apply the various capital approaches on typical portfolio strategies observed within financial institutions.

There is currently a strong market focus on counterparty credit risk and more specifically on Credit Value Adjustment (CVA). The attention is predominantly towards the issue of efficient CVA pricing as opposed to implications in terms of risk management and capital requirements. However, since the recent crisis, another issue has gained prominence; the significant losses that counterparty credit risk can cause if not correctly managed.

Authored by Rohan Douglas, CEO Quantifi, Dr. Dmitry Pugachevsky, Director of Research, Quantifi, Dr. Jean-Roche Sibille, Risk Dynamics, and Aurelie Civilio, Risk Dynamics.

Quantifi Whitepaper — Comparing Alternative Methods for Calculating CVA Capital Charges Under Basel III

- Quantifi

The global financial crisis brought counterparty credit risk and CVA very much into the spotlight. The Basel III proposals first published in December 2009 introduced changes to the Basel II rules and the need for a new capital charge against the volatility of CVA. This ‘CVA VaR’ capital charge was always likely to be punitive since the Basel committee considered that it referenced two thirds of counterparty risk related losses. However, there are two ways for banks to compute CVA VaR, so-called standardised and advanced methods, which depend on their current regulatory approval with respect to other aspects. Furthermore, there is the potential to reduce the capital charges via eligible hedges. This paper aims to explore the capital charges under the two regimes and the capital relief that can be achieved.

Authored by Dmitry Pugachevsky, Director of Research, Quantifi, Rohan Douglas, CEO, Quantifi and Jon Gregory

Reflecting credit and funding adjustments in fair value

- Ernst & Young

Countering the Risk of Counterparties: Emerging Trends, Practices, and Technology in CVA Management

- Celent

Basel III: Issues and Implications White Paper

- KPMG

Summary of key details of the Basel III capital adequacy framework and exploration of some practical implications and considerations for firms to establish an effective and efficient implementation procedure.

- GARP

CVA desks have been developed in response to crisis-driven regulations for improved counterparty risk management. How do these centralized groups differ from traditional approaches to manage counterparty risk, and what types of data and analytical challenges do they face?