The credit crisis of 2008 stressed the financial system considerably. The bankruptcy of some of the significant players such as Lehman, have led market participants to re-evaluate the pre-crisis view that counterparties are largely risk free. This has brought about an increased focus on counterparty risk management practices as participants try to bolster their systems and infrastructure to correctly assess and monitor these risks.
This calls for building sophisticated Monte Carlo simulation engines for calculating key exposure measures, such as Potential Future Exposure (PFE) and Expected Positive Exposure (EPE). PFE is the maximum amount of Expected Exposure (EE) on a future date with a certain degree of statistical confidence. EPE is the average exposure on a future date. Further, these exposures could be positively or negatively correlated with the credit risk of the counterparty resulting in wrong way or right way risk.
The simulation engine computes the exposure levels by aggregating along each path/scenario, for a counterparty, the value of all trades while considering the netting and collateral arrangement with that counterparty. These netting and collateral arrangements, together with hedging, form an important way of mitigating counterparty credit risk.
The collateral policy is governed by Credit Support Annex (CSA) of the master agreement, to which both parties to the transaction are signatories. For transactions that are fully collateralized, the Overnight Index Swap (OIS) rate has become the new measure of risk-free rate. The CSA may specify that the collateral may be posted in multiple currencies. Hence the risk-free rate is a "cheapest to deliver" curve that is arrived at by blending the OIS rates in different currencies.
FVA, CVA, DVA - XVA
However, for uncollateralized and “non-perfectly” collateralized transactions, the industry seems to have gravitated towards incorporating the cost of the funding in the fair value of the instrument. This additional charge is referred to as Funding Valuation Adjustment (FVA), and the (initial) Margin Valuation Adjustment is the MVA. This is the funding cost of the margin.
In addition to these adjustments, the solvency of counterparties of financial transactions directly contributes to determining the ultimate fair value of a financial instrument. Specifically, the industry is moving towards a practice where the erstwhile fair value needs to be enhanced with a Credit and a Debt Valuation Adjustment (CVA and DVA respectively). The CVA charge is to account for the potential loss for an entity due to the default of the counterparty at a time during the life time of the trade when the fair value is in its favor. Similarly, the DVA charge is to account for the potential gain arising from not having to pay for its liability on account of its own default.
The accounting standards have also progressed meanwhile, to account for these new developments. IRFS 13, which became effective from Jan 2013, stipulates that DVA must be recorded in addition to the CVA. CVA is now part of the regulatory Capital and Risk Weighted Asset (RWA) calculation introduced under Basel III.
The capital requirements under Basel II regulatory calculations lead to another valuation adjustment, i.e., the KVA or capital valuation adjustment. Together these adjustments are referred to as XVA.
Solutions
The Prudential and Risk Management practice at Kroll provides an expert team of quantitative analysts together with a library of cutting-edge valuation and risk models to assist our clients with enhancing their counterparty risk management practices.
Specifically, our areas of expertise include:
- Computation of PFE and EPE for portfolios of financial assets.
- Valuation of KVA and CVA charge and sensitivities on portfolios of derivatives and complex assets.
- Model validation for client’s models for XVA, i.e., FVA, MVA, KVA, CVA and DVA.
- Providing analytics and subsequent support for integration with in-house systems.
- Assistance and advisory work in implementation of counterparty risk management systems.
- Training on best practices on counterparty risk advisory.
- Hedging strategies for CVA and DVA.
Examples of Recent Risk Solutions Engagements
- Provided counterparty risk management advisory to a European bank with regards to its equity derivatives portfolio. The work involved review of current best practice for equity derivatives analytics, and thereafter design and implementation of PFE analytics for structured equity products. The products included were American and European options and equity swaps. Kroll analysts worked on the client site to access the existing practice and thereafter to deploy the new analytics in the client’s environment.
- Provided models to a large Asian bank to allow them to value and calculate market risk for their credit derivatives portfolio.
- Advised a structured products start-up hedge fund on the creation of policies and procedures and served as valuation and risk advisor.
