The xVA Challenge: Counterparty Credit Risk, Funding, Collateral, and Capital

A detailed, expert–driven guide to today?s major financial point of interest The xVA Challenge: Counterparty Credit Risk, Funding, Collateral, and Capital is a practical guide from one of the leading and most influential credit practitioners, Jon Gregory. Focusing on practical methods, this informative guide includes discussion around the latest regulatory requirements, market practice, and academic thinking. Beginning with a look at the emergence of counterparty risk during the recent global financial crisis, the discussion delves into the quantification of firm–wide credit exposure and risk mitigation methods, such as netting and collateral. It also discusses thoroughly the xVA terms, notably CVA, DVA, FVA, ColVA, and KVA and their interactions and overlaps. The discussion of other aspects such as wrong–way risks, hedging, stress testing, and xVA management within a financial institution are covered. The extensive coverage and detailed treatment of what has become an urgent topic makes this book an invaluable reference for any practitioner, policy maker, or student. Counterparty credit risk and related aspects such as funding, collateral, and capital have become key issues in recent years, now generally characterized by the term ?xVA?. This book provides practical, in–depth guidance toward all aspects of xVA management. Market practice around counterparty credit risk and credit and debit value adjustment (CVA and DVA) The latest regulatory developments including Basel III capital requirements, central clearing, and mandatory collateral requirements The impact of accounting requirements such as IFRS 13 Recent thinking on the applications of funding, collateral, and capital adjustments (FVA, ColVA and KVA) The sudden realization of extensive counterparty risks has severely compromised the health of global financial markets. It?s now a major point of action for all financial institutions, which have realized the growing importance of consistent treatment of collateral, funding, and capital alongside counterparty risk. The xVA Challenge: Counterparty Credit Risk, Funding, Collateral, and Capital provides expert perspective and real–world guidance for today?s institutions. INDICE: List of Spreadsheets xix .List of Appendices xxi .Acknowledgements xxiii .About the Author xxv .1 Introduction 1 .2 The Global Financial Crisis 3 .2.1 Pre–crisis 3 .2.2 The crisis 5 .2.3 Regulatory reform 8 .2.4 Backlash and criticisms 8 .2.5 A new world 10 .3 The OTC Derivatives Market 11 .3.1 The derivatives market 11 .3.1.1 Derivatives 11 .3.1.2 Exchange traded and OTC derivatives 12 .3.1.3 Market size 12 .3.1.4 Market participants 14 .3.1.5 Credit derivatives 16 .3.1.6 The dangers of derivatives 17 .3.1.7 The Lehman experience 17 .3.2 Derivative risks 18 .3.2.1 Market risk 18 .3.2.2 Credit risk 19 .3.2.3 Operational and legal risk 19 .3.2.4 Liquidity risk 20 .3.2.5 Integration of risk types 20 .3.2.6 Counterparty risk 20 .3.3 Risk management of derivatives 20 .3.3.1 Value–at–risk 20 .3.3.2 Models 23 .3.3.3 Correlation and dependency 23 .4 Counterparty Risk 25 .4.1 Background 25 .4.1.1 Counterparty risk versus lending risk 25 .4.1.2 Settlement and pre–settlement risk 26 .4.1.3 Mitigating counterparty risk 28 .4.1.4 Exposure and product type 29 .4.1.5 Setups 31 .4.2 Components 32 .4.2.1 Mark–to–market and replacement cost 33 .4.2.2 Credit exposure 33 .4.2.3 Default probability, credit migration and credit spreads 34 .4.2.4 Recovery and loss given default 35 .4.3 Control and quantification 36 .4.3.1 Credit limits 36 .4.3.2 Credit value adjustment 38 .4.3.3 CVA and credit limits 38 .4.3.4 What does CVA represent? 39 .4.3.5 Hedging counterparty risk 41 .4.3.6 The CVA desk 42 .4.4 Beyond CVA 43 .4.4.1 Overview 43 .4.4.2 Economic costs of an OTC derivative 43 .4.4.3 xVA terms 44 .4.5 Summary 46 .5 Netting, Close–out and Related Aspects 47 .5.1 Introduction 47 .5.1.1 Overview 47 .5.1.2 The need for netting and close–out 47 .5.1.3 Payment and close–out netting 48 .5.2 Default, netting and close–out 49 .5.2.1 The ISDA Master Agreement 49 .5.2.2 Events of default 49 .5.2.3 Payment netting 50 .5.2.4 Close–out netting 51 .5.2.5 Product coverage and set–off rights 52 .5.2.6 Close–out amount 53 .5.2.7 The impact of netting 55 .5.3 Multilateral netting and trade compression 56 .5.3.1 Overview 56 .5.3.2 Multilateral netting 56 .5.3.3 Bilateral compression services 57 .5.3.4 The need for standardisation 58 .5.3.5 Examples 58 .5.4 Termination features and resets 61 .5.4.1 Walkaway features 61 .5.4.2 Termination events 62 .5.4.3 Reset agreements 64 .5.5 Summary 65 .6 Collateral 67 .6.1 Introduction 67 .6.1.1 Rationale for collateral 67 .6.1.2 Analogy with mortgages 69 .6.1.3 Variation margin and initial margin 69 .6.2 Collateral terms 70 .6.2.1 The credit support annex (CSA) 70 .6.2.2 Types of CSA 71 .6.2.3 Threshold 73 .6.2.4 Initial margin 74 .6.2.5 Minimum transfer amount and rounding 74 .6.2.6 Haircuts 75 .6.2.7 Linkage to credit quality 77 .6.2.8 Credit support amount 78 .6.2.9 Impact of collateral on exposure 79 .6.3 Mechanics of collateral 80 .6.3.1 Collateral call frequency 80 .6.3.2 Valuation agents, disputes and reconciliations 81 .6.3.3 Title transfer and security interest 82 .6.3.4 Coupons, dividends and remuneration 83 .6.4 Collateral and funding 84 .6.4.1 Overview 84 .6.4.2 Substitution 84 .6.4.3 Rehypothecation 85 .6.4.4 Segregation 87 .6.4.5 Variation and initial margin rehypothecation and segregation 88 .6.4.6 Standard CSA 89 .6.5 Collateral usage 90 .6.5.1 Extent of collateralisation 90 .6.5.2 Coverage of collateralisation 91 .6.5.3 Collateral type 92 .6.6 The risks of collateral 93 .6.6.1 Collateral impact outside OTC derivatives markets 93 .6.6.2 Market risk and the margin period of risk 94 .6.6.3 Operational risk 96 .6.6.4 Legal risk 97 .6.6.5 Liquidity risk 98 .6.6.6 Funding liquidity risk 98 .6.7 Regulatory collateral requirements 100 .6.7.1 Background 100 .6.7.2 Covered entities 101 .6.7.3 General requirements 102 .6.7.4 Haircuts 104 .6.7.5 Segregation and rehypothecation 105 .6.7.6 Initial margin calculations 105 .6.7.7 Standardised initial margin method (SIMM) 106 .6.8 Converting counterparty risk into funding liquidity risk 107 .6.9 Summary 108 .7 Credit Exposure and Funding 109 .7.1 Credit exposure 109 .7.1.1 Definition 109 .7.1.2 Bilateral exposure 110 .7.1.3 The close–out amount 111 .7.1.4 Exposure as a short option position 111 .7.1.5 Future exposure 112 .7.1.6 Comparison to value–at–risk 113 .7.2 Metrics for exposure 114 .7.2.1 Expected future value 114 .7.2.2 Potential future exposure 115 .7.2.3 Expected exposure 116 .7.2.4 EE and PFE for a normal distribution 116 .7.2.5 Maximum PFE 117 .7.2.6 Expected positive exposure 117 .7.2.7 Negative exposure 118 .7.2.8 Effective expected positive exposure (EEPE) 118 .7.3 Factors driving exposure 119 .7.3.1 Loans and bonds 119 .7.3.2 Future uncertainty 120 .7.3.3 Periodic cashflows 120 .7.3.4 Combination of profiles 125 .7.3.5 Optionality 126 .7.3.6 Credit derivatives 128 .7.4 The impact of netting and collateral on exposure 129 .7.4.1 The impact of netting on future exposure 129 .7.4.2 Netting and the impact of correlation 130 .7.4.3 Netting and relative MTM 132 .7.4.4 Impact of collateral on exposure 133 .7.5 Funding, rehypothecation and segregation 135 .7.5.1 Funding costs and benefits 135 .7.5.2 Differences between funding and credit exposure 136 .7.5.3 Impact of segregation and rehypothecation 136 .7.5.4 Impact of collateral on credit and funding exposure 138 .7.5.5 Examples 140 .7.6 Summary 141 .8 Capital Requirements and Regulation 143 .8.1 Background to credit risk capital 144 .8.1.1 Standardised approach 144 .8.1.2 Internal ratings–based approach (IRB) 144 .8.1.3 Double default 145 .8.1.4 Exposure at default (EAD) 146 .8.1.5 Incurred CVA 148 .8.2 Current exposure method (CEM) 148 .8.2.1 Add–ons 148 .8.2.2 Netting and collateral treatment 149 .8.3 The internal model method (IMM) 151 .8.3.1 Background 151 .8.3.2 The alpha factor and EEPE 151 .8.4 Standardised approach for counterparty credit risk (SA–CCR) 153 .8.4.1 Background 153 .8.4.2 Basic approach 154 .8.4.3 Netting 155 .8.4.4 Collateral 156 .8.4.5 Overcollateralisation and negative MTM 157 .8.5 Comparison of EAD methods 157 .8.5.1 Impact of maturity 157 .8.5.2 Collateral 158 .8.5.3 Negative MTM 159 .8.5.4 Initial margin and threshold 159 .8.5.5 Netting 160 .8.6 Basel III 161 .8.6.1 Overview 161 .8.6.2 Stressed EPE 163 .8.6.3 Increased margin period of risk 163 .8.6.4 Backtesting 164 .8.6.5 Wrong–way risk 166 .8.6.6 Stress testing 167 .8.7 CVA capital charge 168 .8.7.1 Rationale 168 .8.7.2 Standardised formula 169 .8.7.3 Advanced approach 171 .8.7.4 Example 174 .8.7.5 Criticisms 176 .8.7.6 US implementation 178 .8.7.7 The European exemptions 178 .8.8 Other important regulatory requirements 180 .8.8.1 Fundamental review of the trading book 180 .8.8.2 Leverage ratio 180 .8.8.3 Floors 181 .8.8.4 Liquidity coverage ratio and net stable funding ratio 182 .8.8.5 Prudent value 182 .8.9 Summary 183 .9 Counterparty Risk Intermediation 185 .9.1 Introduction 185 .9.2 SPVs, DPCs, CDPCs and monolines 187 .9.2.1 Default remoteness and too big to fail 187 .9.2.2 Special purpose vehicles 187 .9.2.3 Derivative product companies 188 .9.2.4 Monolines and CDPCs 190 .9.3 Central counterparties 192 .9.3.1 The clearing mandate 193 .9.3.2 OTC clearing 193 .9.3.3 The CCP landscape 195 .9.3.4 CCP risk management 196 .9.3.5 Comparing bilateral and central clearing 199 .9.3.6 Advantages and disadvantages of CCPs 200 .9.3.7 CCP capital charges 201 .9.3.8 What central clearing means for xVA 202 .9.4 Summary 203 .10 Quantifying Credit Exposure 205 .10.1 Introduction 205 .10.2 Methods for quantifying credit exposure 205 .10.2.1 Parametric approaches 205 .10.2.2 Semi–analytical methods 206 .10.2.3 Monte Carlo simulation 209 .10.3 Monte Carlo methodology 210 .10.3.1 Simulation model 210 .10.3.2 Scenario generation 211 .10.3.3 Revaluation 212 .10.3.4 Aggregation 215 .10.3.5 Post–processing 215 .10.3.6 Extraction 216 .10.4 Real–world or risk–neutral 216 .10.4.1 Two fundamentally different approaches 216 .10.4.2 Drift 219 .10.4.3 Volatility 220 .10.4.4 Correlation 221 .10.4.5 Market practice 221 .10.5 Model choice 222 .10.5.1 Risk–neutral or real–world? 222 .10.5.2 Level of complexity 224 .10.5.3 General comments 226 .10.5.4 Correlations 227 .10.6 Examples 228 .10.6.1 Data set 228 .10.6.2 Exposures profiles 230 .10.7 Allocating exposure 235 .10.7.1 Simple two–transaction, single–period example 235 .10.7.2 Incremental exposure 237 .10.7.3 Marginal exposure 240 .10.8 Summary 243 .11 Exposure and the Impact of Collateral 245 .11.1 Overview 245 .11.1.1 General impact of collateral 245 .11.1.2 Modelling approach 246 .11.2 Margin period of risk 247 .11.2.1 Setup 247 .11.2.2 Amortisation 248 .11.2.3 Conditionality 249 .11.2.4 Disputes 249 .11.2.5 MPR discretisation and cashflows 250 .11.2.6 MPR modelling 251 .11.3 Numerical examples 252 .11.3.1 Collateral assumptions 252 .11.3.2 Margin period of risk impact 253 .11.3.3 Simple approximations 255 .11.3.4 Discretisation and cashflows 256 .11.3.5 Impact of threshold 257 .11.3.6 Do two–way CSAs always reduce exposure? 258 .11.3.7 Non–cash collateral 260 .11.3.8 Collateral and funding liquidity risk 261 .11.4 Initial margin 262 .11.4.1 Impact of initial margin on exposure 262 .11.4.2 Dynamic initial margins 263 .11.4.3 Segregation and funding exposure 264 .11.5 Summary 265 .12 Default Probabilities, Credit Spreads and Funding Costs 267 .12.1 Overview 267 .12.2 Default probability 267 .12.2.1 Real–world and risk–neutral 267 .12.2.2 The move to risk–neutral 269 .12.2.3 Defining risk–neutral default probabilities 271 .12.2.4 Term structure 272 .12.2.5 Loss given default 273 .12.3 Credit curve mapping 275 .12.3.1 Overview 275 .12.3.2 The CDS market 276 .12.3.3 Loss given default 278 .12.3.4 General approach 278 .12.4 Generic curve construction 280 .12.4.1 General approach 280 .12.4.2 Third party curves 281 .12.4.3 Mapping approach 282 .12.4.4 Cross–sectional approach 283 .12.4.5 Hedging 284 .12.5 Funding curves and capital costs 285 .12.5.1 Background 285 .12.5.2 Funding costs 286 .12.5.3 Defining a funding curve 286 .12.5.4 Cost of capital 288 .12.6 Summary 289 .13 Discounting and Collateral 291 .13.1 Overview 291 .13.2 Discounting 291 .13.2.1 Introduction 291 .13.2.2 OIS rates 292 .13.2.3 The risk–free rate 293 .13.2.4 Perfect collateralisation and discounting 294 .13.2.5 OIS discounting 295 .13.2.6 OIS methodology 296 .13.3 Beyond perfect collateralisation 297 .13.3.1 The push towards perfect collateralisation 297 .13.3.2 The xVA terms 297 .13.4 Collateral valuation adjustments 300 .13.4.1 Overview 300 .13.4.2 Collateral rate adjustments 300 .13.4.3 Collateral optionality 303 .13.4.4 Non–cash collateral 307 .13.4.5 The end of ColVA 307 .13.5 Summary 308 .14 Credit and Debt Value Adjustments 309 .14.1 Overview 309 .14.2 Credit value adjustment 309 .14.2.1 Why CVA is not straightforward 309 .14.2.2 History of CVA 310 .14.2.3 CVA formula 311 .14.2.4 CVA example 312 .14.2.5 CVA as a spread 313 .14.2.6 Exposure and discounting 313 .14.2.7 Risk–neutrality 314 .14.2.8 CVA semi–analytical methods 314 .14.3 Impact of credit assumptions 315 .14.3.1 Credit spread impact 315 .14.3.2 Recovery impact 316 .14.4 CVA allocation and pricing 317 .14.4.1 Netting and incremental CVA 317 .14.4.2 Incremental CVA example 319 .14.4.3 Marginal CVA 319 .14.4.4 CVA as a spread 321 .14.4.5 Numerical issues 321 .14.5 CVA with collateral 323 .14.5.1 Impact of margin period of risk 324 .14.5.2 Thresholds and initial margins 324 .14.6 Debt value adjustment 326 .14.6.1 Overview 326 .14.6.2 Accounting standards and DVA 326 .14.6.3 DVA and pricing 327 .14.6.4 Bilateral CVA formula 327 .14.6.5 Close–out and default correlation 328 .14.6.6 Example 330 .14.6.7 DVA and own–debt 331 .14.6.8 DVA in derivatives 332 .14.7 Summary 334 .15 Funding Value Adjustment 335 .15.1 Funding and derivatives 335 .15.1.1 Why there are funding costs and benefits 335 .15.1.2 The nature of funding costs and benefits 336 .15.1.3 Relationship to CVA and DVA 338 .15.1.4 FVA in financial statements 339 .15.2 Funding value adjustment 341 .15.2.1 Intuitive definition 341 .15.2.2 Discounting approach 343 .15.2.3 More complex cases 345 .15.2.4 Contingent FVA 347 .15.2.5 Allocation of FVA 348 .15.3 The practical use of FVA 349 .15.3.1 Link to DVA 349 .15.3.2 CVA/DVA/FVA framework 350 .15.3.3 Is FVA really symmetric? 351 .15.3.4 Defining the funding rate 351 .15.3.5 The Hull and White and accounting arguments 352 .15.3.6 Resolving the FVA debate 354 .15.3.7 Remaining issues 355 .15.3.8 Example 356 .15.4 Summary 357 .16 LCH/CME Basis and Capital Value Adjustments 359 .16.1 Overview 359 .16.2 Margin value adjustment 360 .16.2.1 Rationale 360 .16.2.2 IM profiles 361 .16.2.3 MVA formula 364 .16.2.4 Example 365 .16.3 Capital value adjustment 366 .16.3.1 Rationale 366 .16.3.2 Capital profiles 368 .16.3.3 Formula 369 .16.3.4 Term structure behaviour 370 .16.3.5 Behavioural aspects and regulatory change 371 .16.3.6 Example 372 .16.3.7 KVA and MVA 373 .16.3.8 Overlaps and hedging 374 .16.3.9 KVA reporting 375 .16.4 Summary 375 .17 Wrong–way Risk 377 .17.1 Overview 377 .17.2 Overview of wrong–way risk 377 .17.2.1 Simple example 377 .17.2.2 Classic example and empirical evidence 378 .17.2.3 General and specific WWR 379 .17.2.4 WWR challenges 380 .17.3 Quantification of wrong–way risk 380 .17.3.1 Wrong–way risk and CVA 380 .17.3.2 Simple example 381 .17.3.3 Wrong–way collateral 382 .17.4 Wrong–way risk modelling approaches 383 .17.4.1 Hazard rate approaches 383 .17.4.2 Structural approaches 385 .17.4.3 Parametric approach 387 .17.4.4 Jump approaches 388 .17.4.5 Credit derivatives 390 .17.4.6 Wrong–way risk and collateral 391 .17.4.7 Central clearing and wrong–way risk 393 .17.5 Summary 395 .18 xVA Management 397 .18.1 Introduction 397 .18.2 The role of an xVA desk 397 .18.2.1 Motivation 397 .18.2.2 Role 398 .18.2.3 Profit centre or utility? 399 .18.2.4 Operation and rollout 400 .18.3 Hedging xVA 403 .18.3.1 Motivation 403 .18.3.2 xVA as an exotic option 403 .18.3.3 Misalignment 404 .18.3.4 Market risk 405 .18.3.5 Credit, funding and capital hedging 406 .18.3.6 Cross–gamma 406 .18.3.7 P&L explain 407 .18.3.8 Capital relief from hedges 407 .18.3.9 Market practice and hedging 411 .18.4 xVA systems 412 .18.4.1 Overview 412 .18.4.2 Optimisations 413 .18.4.3 Shared or separate implementations 414 .18.4.4 Internal and vendor systems 416 .18.4.5 IMM approval 418 .18.5 Summary 419 .19 xVA Optimisation 421 .19.1 Overview 421 .19.2 Market practice 422 .19.2.1 General approach to xVA 422 .19.2.2 Totem 424 .19.3 Examples 425 .19.3.1 xVA assumptions 425 .19.3.2 Uncollateralised 426 .19.3.3 Off–market 427 .19.3.4 Partially collateralised 428 .19.3.5 One–way collateralised 429 .19.3.6 Collateralised 430 .19.3.7 Overcollateralised (initial margin) and backloading 430 .19.4 Costs and the balance of xVA terms 433 .19.4.1 Spectrum of transaction 433 .19.4.2 Optimising xVA 434 .19.4.3 Impact of credit quality and maturity 436 .19.4.4 Summary 437 .19.5 xVA optimisation 437 .19.5.1 Intermediation 437 .19.5.2 Restrikes 438 .19.5.3 Uncollateralised to collateralised 439 .19.5.4 Backloading to a CCP 440 .19.6 Summary 441 .20 The Future 443 .Glossary 445 .References 447 .Index 457

• ISBN: 978-1-119-10941-9
• Editorial: John Wiley & Sons
• Encuadernacion: Cartoné
• Páginas: 496
• Fecha Publicación: 04/09/2015
• Nº Volúmenes: 1
• Idioma: Inglés