The Xva Challenge: Counterparty Risk, Funding, Collateral, Capital and Initial Margin

ISBN-13: 9781119508977 / Angielski / Twarda / 2020 / 704 str.

Jon Gregory

Spis treści

List of Spreadsheets xixList of Appendices xxiAcknowledgements xxiiiAbout the Author xxvSection 1 Basics1 Introduction 32 Derivatives 52.1 Introduction 52.2 The Derivatives Market 62.2.1 Exchange-traded and OTC Derivatives 62.2.2 Clearing 82.2.3 Market Overview 92.2.4 Market Participants and Collateralisation 112.2.5 Banks and End Users 142.2.6 ISDA Documentation 162.2.7 Credit Derivatives 172.2.8 Financial Weapons of Mass Destruction 182.2.9 The Lehman Brothers Bankruptcy 192.3 Derivative Risks 202.3.1 Market Risk 212.3.2 Credit Risk 212.3.3 Operational and Legal Risk 222.3.4 Liquidity Risk 222.3.5 Integration of Risk Types 232.3.6 Counterparty Risk 232.4 Systemic Risk of Derivatives 242.4.1 Overview 242.4.2 Special Purpose Vehicles 242.4.3 Derivatives Product Companies 252.4.4 Monolines and CDPCs 262.5 The Global Financial Crisis and Central Clearing of OTC Derivatives 282.5.1 OTC Derivatives and the Crisis 282.5.2 OTC Derivatives Clearing 292.5.3 CCPs in the Global Financial Crisis 312.5.4 The Clearing Mandate 322.5.5 Bilateral Margin Requirements 332.5.6 CCPs in Context 342.6 Derivatives Risk Modelling 362.6.1 Value-at-risk 362.6.2 Models 382.6.3 Correlation and Dependency 393 Counterparty Risk and Beyond 413.1 Counterparty Risk 413.1.1 Counterparty Risk Versus Lending Risk 413.1.2 Settlement, Pre-settlement, and Margin Period of Risk 423.1.3 Mitigating Counterparty Risk 453.1.4 Product Type 463.1.5 Credit Limits 483.1.6 Credit Value Adjustment 503.1.7 What Does CVA Represent? 513.1.8 Hedging Counterparty Risk and the CVA Desk 523.2 Beyond Counterparty Risk 543.2.1 Overview 543.2.2 Economic Costs of a Derivative 543.2.3 xVA Terms 553.3 Components of xVA 573.3.1 Overview 573.3.2 Valuation and Mark-to-market 573.3.3 Replacement Cost and Credit Exposure 583.3.4 Default Probability, Credit Migration, and Credit Spreads 593.3.5 Recovery and Loss Given Default 603.3.6 Funding, Collateral, and Capital Costs 614 Regulation 634.1 Regulation and the Global Financial Crisis 634.2 Capital Requirements 644.2.1 Overview 644.2.2 Capital Ratios 654.2.3 Risk Type 674.2.4 Market Risk Capital 684.2.5 CVA Capital 694.2.6 CCR Capital 704.2.7 Leverage Ratio 704.2.8 Capital Floors 714.2.9 Large Exposure Framework 724.2.10 Bank Stress Tests 734.2.11 Prudent Valuation 734.3 Liquidity 734.3.1 Overview 734.3.2 High-quality Liquid Assets 744.3.3 Liquidity Coverage Ratio 754.3.4 Net Stable Funding Ratio 764.4 Clearing and Margining 774.4.1 Central Clearing 774.4.2 Bilateral Margin Requirements 814.4.3 Exemptions 824.4.4 CCP Capital Requirements 845 What is xVA? 855.1 Overview 855.2 Analysis of xVA 865.2.1 Definition 865.2.2 Components 865.2.3 Why Valuation Adjustments? 875.2.4 Mark-to-market and xVA as a Cost (and Benefit) 885.2.5 xVAs by Transaction Type 905.2.6 Overlaps and Portfolio Effects 915.2.7 CVA is the Least Real Valuation Adjustment 925.3 Valuation 935.3.1 Price and Value 935.3.2 xVA Markets 945.3.3 Accounting Standards 955.3.4 Accounting Trends 985.3.5 Totem 995.3.6 Contractual Terms and Value 1005.4 Pricing 1005.4.1 Reality or Creating the Right Incentive? 1005.4.2 Approach for Capital 1015.4.3 Approach to Regulatory Ratios 1025.4.4 Lack of Arbitrage 1045.4.5 Entry and Exit Pricing 1055.4.6 xVA Quantification 1065.4.7 Special Cases 106Section 2 Risk Mitigation6 Netting, Close-Out, and Related Aspects 1116.1 Overview 1116.2 Cash Flow Netting 1126.2.1 Payment Netting 1126.2.2 Currency Netting and CLS 1136.2.3 Clearing Rings 1146.2.4 Portfolio Compression 1156.2.5 Compression Algorithm 1186.2.6 Benefits of Cashflow Netting 1206.3 Value Netting 1216.3.1 Overview 1216.3.2 Close-out Netting 1216.3.3 Payment Under Close-out 1226.3.4 Close-out and xVA 1246.3.5 ISDA Definitions 1256.3.6 Set-off 1296.4 The Impact of Netting 1306.4.1 Risk Reduction 1306.4.2 The Impact of Netting 1316.4.3 Multilateral Netting and Bifurcation 1326.4.4 Netting Impact on Other Creditors 1357 Margin (Collateral) and Settlement 1377.1 Termination and Reset Features 1377.1.1 Break Clauses 1377.1.2 Resettable Transactions 1407.2 Basics of Margin/Collateral 1417.2.1 Terminology 1417.2.2 Rationale 1427.2.3 Variation Margin and Initial Margin 1447.2.4 Method of Transfer and Remuneration 1457.2.5 Rehypothecation and Segregation 1477.2.6 Settle to Market 1507.2.7 Valuation Agent, Disputes, and Reconciliations 1517.3 Margin Terms 1527.3.1 The Credit Support Annex 1527.3.2 Types of CSA 1537.3.3 Margin Call Frequency 1547.3.4 Threshold, Initial Margin, and the Minimum Transfer Amount 1557.3.5 Margin Types and Haircuts 1577.3.6 Credit Support Amount Calculations 1617.3.7 Impact of Margin on Exposure 1637.3.8 Traditional Margin Practices in Bilateral and Centrally-cleared Markets 1657.4 Bilateral Margin Requirements 1667.4.1 General Requirements 1667.4.2 Phase-in and Coverage 1687.4.3 Initial Margin and Haircut Calculations 1697.4.4 Eligible Assets and Haircuts 1717.4.5 Implementation and Impact of the Requirements 1727.5 Impact of Margin 1737.5.1 Impact on Other Creditors 1737.5.2 Market Risk and Margin Period of Risk 1747.5.3 Liquidity, FX, and Wrong-way Risks 1787.5.4 Legal and Operational Risks 1797.6 Margin and Funding 1807.6.1 Overview 1807.6.2 Margin and Funding Liquidity Risk 1818 Central Clearing 1858.1 Evolution of Central Clearing 1858.1.1 Exchange Trading 1858.1.2 Evolution of Complete Clearing 1868.1.3 What is a CCP? 1878.2 Mechanics of Central Clearing 1898.2.1 Landscape 1898.2.2 Novation 1918.2.3 Multilateral Offset and Compression 1928.2.4 Margin and Default Funds 1948.2.5 Clearing Relationships 1958.3 CCP Risk Management 1978.3.1 Overview and Membership Requirements 1978.3.2 Margin 1988.3.3 Default Scenarios and Margin Period of Risk 1998.3.4 The Loss Waterfall 2028.3.5 Comparing Bilateral and Central Clearing 2048.4 Initial Margin and Default Funds 2058.4.1 Coverage of Initial Margin and Default Funds 2058.4.2 Default Fund Versus Initial Margin 2068.4.3 Default Fund Coverage 2078.5 Impact of Central Clearing 2098.5.1 Advantages and Disadvantages of Central Clearing 2098.5.2 Will Mandatory Clearing Kill Credit Value Adjustment? 2109 Initial Margin Methodologies 2139.1 Role of Initial Margin 2139.1.1 Purpose 2139.1.2 Margin Period of Risk 2159.1.3 Coverage: Quantitative and Qualitative 2179.1.4 Haircuts 2189.1.5 Linkage to Credit Quality 2189.1.6 Cross-margining 2209.2 Initial Margin Approaches 2229.2.1 Simple Approaches 2229.2.2 SPAN® 2239.2.3 Value-at-risk and Expected Shortfall 2279.3 Historical Simulation 2299.3.1 Overview 2299.3.2 Look-back Period 2309.3.3 Relative and Absolute Returns 2319.3.4 Volatility Scaling 2339.3.5 Procyclicality 2349.3.6 Current CCP Methodologies 2399.3.7 Computational Considerations 2419.4 Bilateral Margin and SIMM 2429.4.1 Overview 2429.4.2 Standard Schedules 2449.4.3 Variance-covariance Approaches 2459.4.4 The ISDA SIMM 2499.4.5 Implementation of Bilateral Margin Requirements 25210 The Impact and Risk of Clearing and Margining 25510.1 Risks of Central Clearing 25610.1.1 Historical CCP Problems 25610.1.2 The 1987 Stock Market Crash 25810.1.3 The 2018 Nasdaq Case 25910.1.4 Risks Faced by CCPs 26010.1.5 Risks Caused by CCPs 26110.2 Analysis of a CCP Loss Structure 26210.2.1 Review of the Loss Waterfall 26210.2.2 Impact of Default Fund Exposure 26410.2.3 The Prisoner's Dilemma and AIPs 26510.2.4 Other Loss Allocation Methods 26710.3 Impact of Margin 27110.3.1 Background and Historical Examples 27110.3.2 Variation Margin 27310.3.3 Initial Margin 27510.3.4 Cost and xVA 27610.3.5 Seniority 27710.3.6 Bilateral and Cleared Markets 277Section 3 Building Blocks11 Future Value and Exposure 28311.1 Credit Exposure 28311.1.1 Positive and Negative Exposure 28311.1.2 Definition of Value 28411.1.3 Current and Potential Future Exposure 28511.1.4 Nature of Exposure 28611.1.5 Metrics 28811.2 Drivers of Exposure 29211.2.1 Future Uncertainty 29211.2.2 Cash Flow Frequency 29311.2.3 Curve Shape 29411.2.4 Moneyness 29711.2.5 Combination of Profiles 29811.2.6 Optionality 29911.2.7 Credit Derivatives 30011.3 Aggregation, Portfolio Effects, and the Impact of Collateralisation 30211.3.1 The Impact of Aggregation on Exposure 30211.3.2 Off-market Portfolios 30411.3.3 Impact of Margin 30511.4 Funding, Rehypothecation, and Segregation 30811.4.1 Funding Costs and Benefits 30811.4.2 Differences Between Funding and Credit Exposure 30911.4.3 Impact of Segregation and Rehypothecation 31011.4.4 Impact of Margin on Exposure and Funding 31212 Credit Spreads, Default Probabilities, and LGDs 31512.1 Default Probability 31512.1.1 Real World and Risk Neutral 31512.1.2 CVA and Risk-neutral Default Probabilities 31612.1.3 Defining Risk-neutral Default Probabilities 31912.1.4 Loss Given Default 32112.2 Credit Curve Mapping 32312.2.1 Overview 32312.2.2 The CDS Market 32412.2.3 Loss Given Default 32612.2.4 General Approach 32712.3 Generic Curve Construction 33012.3.1 General Approach 33012.3.2 Intersection (Bucketing) Approach 33212.3.3 Cross-section Methodology 33412.3.4 Curve Shape, Interpolation, and Indices 33612.3.5 Third-party Providers 33712.3.6 Hedging 33813 Regulatory Methodologies 33913.1 Overview 33913.2 Credit Risk (Default Risk) Capital 34113.2.1 Standardised Approach 34113.2.2 Internal Ratings-based Approach 34213.2.3 Guarantees 34313.3 CVA (Market Risk) Capital 34313.3.1 The CVA Capital Charge 34313.3.2 Standardised CVA Risk Capital Charge 34413.3.3 BA-CVA 34513.3.4 Advanced CVA Capital Risk Charge 34813.3.5 SA-CVA 35113.3.6 Capital Relief and EU Exemptions 35513.4 Exposure Calculation Methodologies 35613.4.1 Exposure at Default 35613.4.2 Current Exposure Method 35813.4.3 Standardised Approach for Counterparty Credit Risk 36113.4.4 Broader Impact of SA-CCR 36613.4.5 The Internal Model Method 36713.4.6 The Leverage Ratio 37213.4.7 Wrong-way Risk 37313.5 Examples 37413.5.1 Comparison of EAD Methods 37413.5.2 Comparison of Capital Charges 37713.5.3 Impact of Hedges 37913.6 Central Counterparty Capital Requirements 38413.6.1 Background 38413.6.2 Trade Exposure 38513.6.3 Default Fund Exposure 38513.6.4 Client Clearing 38614 Funding, Margin, and Capital Costs 38914.1 Bank Financing 38914.2 Capital 39114.2.1 Minimum Capital Ratios and Capital Costs 39114.2.2 Leverage Ratio 39314.2.3 Cost of Capital 39414.3 Funding 39414.3.1 Overview 39414.3.2 Cost of Funding 39814.3.3 The Risk-free Rate, IBOR, and OIS 40014.3.4 IBOR Transition 40214.3.5 Funding Spreads 40314.3.6 NSFR and LCR 40614.3.7 Accounting 40615 Quantifying Exposure 40915.1 Methods for Quantifying Exposure 40915.1.1 Overview 40915.1.2 Parametric Approaches 41015.1.3 Semianalytical Methods 41115.1.4 Monte Carlo Simulation 41415.2 Exposure Allocation 41415.2.1 Overview 41415.2.2 Incremental and Marginal Exposure 41415.2.3 Impact of Dependency 41715.3 Monte Carlo Methodology 41915.3.1 Basic Framework 41915.3.2 Revaluation, Cash Flow Bucketing, and Scaling 42115.3.3 Risk-neutral or Physical Measure 42315.3.4 Aggregation Level 42915.4 Choice of Models 43015.4.1 Overview 43015.4.2 Interest Rates 43215.4.3 Foreign Exchange 43515.4.4 Other Asset Classes 43715.4.5 Correlations, Proxies, and Extrapolation 43715.5 Modelling Margin (Collateral) 43915.5.1 Overview 43915.5.2 Margin Period of Risk 44115.5.3 Modelling Approach 44215.5.4 Initial Margin 44515.6 Examples 44815.6.1 Interest Rate Swap Example 44815.6.2 Trade-level Exposures 45015.6.3 Portfolio Exposures 45215.6.4 Notional Resets 45615.6.5 Impact of Variation Margin 45715.6.6 Impact of Initial Margin 460Section 4 The xVAs16 The Starting Point and Discounting 46516.1 The Starting Point 46516.1.1 Basic Valuation 46516.1.2 Perfect Collateralisation 46616.1.3 Collateral or OIS Discounting 46716.2 ColVA and Discounting 46916.2.1 Definition of ColVA 46916.2.2 Asymmetry 47016.2.3 Cheapest-to-deliver Optionality 47316.2.4 Non-cash Margin 47816.2.5 The End of ColVA 47916.3 Beyond Perfect Collateralisation - xVA 48016.3.1 Overview 48016.3.2 Definition of xVA Terms 48217 CVA 48517.1 Overview 48517.2 Credit Value Adjustment 48617.2.1 CVA Compared to Traditional Credit Pricing 48617.2.2 Direct and Path-wise CVA Formulas 48717.2.3 CVA as a Spread 49217.2.4 Special Cases 49317.2.5 Credit Spread Effects 49317.2.6 Loss Given Default 49517.3 Debt Value Adjustment 49817.3.1 Accounting Background 49817.3.2 DVA, Price, and Value 49917.3.3 Bilateral CVA Formula 50017.3.4 Close-out and Default Correlation 50217.3.5 The Use of DVA 50317.4 CVA Allocation 50617.4.1 Incremental CVA 50617.4.2 Marginal CVA 50917.5 Impact of Margin 51017.5.1 Overview 51017.5.2 Example 51117.5.3 Initial Margin 51217.5.4 CVA to CCPs 51317.6 Wrong-way Risk 51417.6.1 Overview 51417.6.2 Quantification of WWR in CVA 51617.6.3 Wrong-way Risk Models 51817.6.4 Jump Approaches 52217.6.5 Credit Derivatives 52417.6.6 Collateralisation and WWR 52517.6.7 Central Clearing and WWR 52618 FVA 52918.1 Overview 52918.2 FVA and Discounting 53018.2.1 Market Practice 53018.2.2 Source of Funding Costs and Benefits 53118.2.3 Definition of FVA 53418.2.4 Symmetric FVA Formula 53518.2.5 CVA/DVA/FVA Framework 53918.2.6 The FVA Debate 54618.2.7 Funding Costs and FVA Accounting 54818.3 Asymmetric FVA 55118.3.1 Overview 55118.3.2 Asymmetric FVA 55218.3.3 FVA Allocation 55518.3.4 NSFR Invariance 55818.3.5 Funding Strategies 56018.3.6 LCR Costs 56118.3.7 Funding and Wrong-way Risk 56319 KVA 56519.1 Overview 56519.2 Capital Value Adjustment (KVA) 56619.2.1 Return on Capital 56619.2.2 KVA Formula 56719.2.3 Capital Profiles 56819.2.4 KVA Example 57219.2.5 Implementation of KVA 57319.2.6 The Leverage Ratio 57519.3 Management of KVA 57719.3.1 Current Treatment of KVA by Banks 57719.3.2 Optimal KVA Management 58019.3.3 Discounting 58519.3.4 KVA Accounting 58519.4 KVA Overlaps 58719.4.1 CVA and KVA 58719.4.2 FVA and KVA 58920 MVA 59120.1 Overview 59120.2 Initial Margin Funding Costs 59420.2.1 Introduction 59420.2.2 MVA Formula 59420.2.3 EIM Term 59520.2.4 Computation Challenges 59920.2.5 Pricing and MVA Example 60020.3 MVA 60220.3.1 A Need to Charge MVA? 60220.3.2 Accounting MVA 60320.3.3 Contingent MVA 60320.3.4 CCP Basis 60420.4 Link to KVA 60620.4.1 Overview 60620.4.2 Example 60721 Actively Managing xVA and the Role of an xVA Desk 60921.1 The Role of an xVA Desk 60921.1.1 Motivation 60921.1.2 Charging Structure and Coverage 61121.1.3 Time Decay 61421.1.4 Profit Centre or Utility? 61521.1.5 Pricing 61721.2 Hedging 61921.2.1 Overview 61921.2.2 Sensitivities 62121.2.3 Gamma, Cross-gamma, Tail Risk, and Rebalancing 62521.2.4 Market Practice 62721.2.5 Jump to Default Risk 62921.2.6 Beta Hedging 63021.2.7 Risk Limits and P&L Explain 63121.2.8 Examples 63321.2.9 Impact on Capital 63421.2.10 Pushing xVA into Base Value 63821.3 Operation of an xVA Desk 63821.3.1 Interaction with a Treasury 63821.3.2 Capital 64021.3.3 Systems and Quantification 64121.3.4 xVA Optimisation 645Glossary 649References 653Index 667

O autorze

JON GREGORY, PHD, is an independent expert specialising in counterparty risk and related aspects. He has worked on many aspects of credit risk in his career, being previously with Barclays Capital, BNP Paribas and Citigroup. He is a senior advisor for Solum Financial Derivatives Advisory and is a faculty member for the Certificate of Quantitative Finance (CQF). Jon has a PhD from Cambridge University.