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Consistent Accounting
V Fair
V FC CVA
Terms
V Fair
V FC
CVA
FVA
FVA
Explanation
u
u
X=u+L
L
Equity
Businesses
Debt Issues
and
Securities
Investments
Asset
Liability
Deposits
Issue debt
Issue equity
Convertible bond
Funding centers
Practical difficulty to compare different
funding activities
Unsecured Lending/Borrowing
Lend $1
Cpty
t=0
t=T
Lend $1
Lend $1
Funding
Desk
LOB
FundDesk
Borrowing
Market
Lending
CPTY
Borrowing
LOB
Lending
LOB
Borrowing
$1
-$1
$1
-$1
$1
-$1
-$1.2
$1.2
-$1.1
$1.1
-$1.1
$1.1
Derivative Activity
(CVA/DVA/FVA)
FundDesk
Lending
Market
Lender
Internal Funding
Transfer
External
Borrowing
Assumptions
Applies to financial institutions with high leverage
At any given time, there is an equilibrium funding cost for the firm. Assuming the
existence of a funding curve.
Funding policy and operations varies from firm to firm
Given a policy and funding curve
Firm should be marking the future cash flow exactly the same way, whether it is
issued debt or swaps or complex derivatives
Debt issuance spread would give the funding level across maturities
Funding spread include: Firms credit, Markets liquidity
The same discounting should be applied for derivatives
Assumptions
There is one true economic value for each market participant for a given trade
Every market participants economic value could be different for the same trade
Different valuation reflects the competitiveness of the market participants
Market Price Markets average exit value
same way as LIBOR as average funding rate
Valued based on average funding rate
Funding value adjustment (FVA) depends on how one treats all other adjustments
A lot of confusion as to what is FVA
It is a relative value
Base: Fully collateralized. Base + Credit + Funding
Funding value adjustment Collateral value Part of discounting spread
Individual
Businesses
LOB1
+++
LOB2
++
LOB3
*
*
*
LOBn
*
*
*
---
Given funding spread X at firm level, all LOBs mark book based on X
The sum of funding/cost reflect the total funding requirements at the firm level
Funding from outside at firm level balanced with sum of all LOBs funding needs
Individual business level funding X marking Equivalent Market value for LOBs +
apply funding X at the firm level
Proper incentive for the individual businesses
LCH Pricing
Margin rule +
Incrementl Risk
LCH /
CME ?
CME Pricing
CME
CCP
Differential
Discounting
Pricing
Secured Pricing
CSA / CCP?
YES
CSA
CVA ~ 0
Collateral asset
Collateral CCY
Fully
Collateralized?
SCEN
NO
Collateralized
Portion
CSA Pricing
Collateral
Thrshld
Rating Trigger
Break Clause
Un-collateralized
Portion
SCEN
CVA
Funding
Cost/Benefit
Differential Discounting
Basic Funding Spread Curves
Differential Discounting
Classify all funding
situations, construct
funding curves
Collateral Currency
Xccy spread curve
Optimal xccy funding
Collateral Asset
Cash/Treasury
Agency GSE
Corporates
Munis
Break Clause
Example:
A CSA governed Swaption settle into LCH Swap
CSA
Discounting
t=0
LCH Swap:
OIS Discounting
Option
Expiry
Swap
Maturity
Example:
Break/Trigger/Exit Clause/Mutual Put/Replacement
Credit Risk
Exposure
No Credit risk
Break
Date 1
t=0
Deal
Maturity
CVA: No Credit risk after break date, limited tenor risk paid at day one
FVA: Discounting for cashflow after break date is ambiguous
FVA: Average market funding is LIBOR?
Replacement event ?
Collateral discounting
scenario rating
scenario valuation
scenario threshold
Unsecured: -Min(-V,H)
V<0
No DVA
Fund Benefit: Min(-V,H)*X*dt
Rating Trigger
scenario triggered?
Break Clause
Collateralized: Max(V-H,0)
V>0
No CVA
Collateral Discounting
Unsecured: Min(V,H)
Credit Exposure: Min(V,H)
CVA: Min(V,H)*u*dt
Funding cost: Min(V,H)*X*dt
CSA
Exposure
Credit
Aggregation
Funding
CVA
FVA
Credit
Capital Requirement:
Counterparty Credit risk (Basel II)
CVA VaR based (Basel III)
Advanced/Standardized approach
Break/Default Clause
Collateral Definition
Collateral Asset
Collateral Currency
Hair Cut
Initial margins
Collateral Damage
Mutual put
Termination event (ATE)
Legal/Netting
Collateral Modeling
Collateral choice: static funding
curve. Optionality impractical.
Hair cuts/Margins
Live Trading
Live Pricing/Quoting
Incremental CVA/FVA Calc
Credit Risk
Specific Name risk
Generic credit risk
Downgrade/Default risk
Hedging strategy
Capital Requirement
CVA VaR
BASEL III Capital
Standardize vs Advanced methodology
Pricing,
Risk Management,
Hedging and
Perf Measurement
Scenarios
Generation
Credit Risk
Specific Name credit buckets
Generic Index credit buckets, hedge ratio
Proxy hedges, hedge ratio
Each Scenario
Market, Credit
Simulations, and
Aggregations
Regularoty Requirement
Credit sensitivities for CVA VaR
Stress testing: market and credit
Sensitivities
Buckets
Hedge Ratio etc
Each Scenario
Market, Credit
Simulations, and
Aggregations
Efficient Computing
Efficient CVA/FVA computation
design
Adjoint Algorithmic Differentiation
Node
Node
Node
Node
Node
Distributed Computing
Sensitivities
Buckets
Hedge Ratio etc
GRID Computing
GPU Computing
CVA/FVA Calculations
Backward Pricing: credit/funded discounting
e ( r u ) t e rt 1 (1 R ) P d
CVA
E ( t )( 1 R ) P d ( t ) D ( t ) dt
FVA
E ( t ) X ( t ) D ( t ) dt
Backward Discounting:
Pros:
Easy to incorporate spread impact
Can incorporate credit impact on exercise boundary
Cons:
Difficult to net portfolio of deals with same CSA
Difficult to apply more complex CSA terms
Difficult to calculate wrong way risk, incremental CVA
Forward Simulation:
Pros:
Can net portfolio deals across same CSA easily
Can deal with very complex CSA terms easily
Fast computation of wrong way risk and incremental CVA
Cons:
Need to develop a global simulation model and a complex correlation model
Approximation: exercise boundary not affected by credit/funding
CVA/FVA Calculations
Forward Simulations Steps
Consistent multicurrency/asset simulations (IR, FX, Equity )
Along with credit simulations + ratings transition
Valuation of all instruments once market factor exposure
Aggregation of market factor exposure with credit/ratings
Application of netting and CSA
Collect default loss and funding cost/benefits
CSA Complexity
Credit Rating
Collateral
Threshold
AAA
50M
AA
20M
5M
BBB
0M
Credit Rating
Event
BBB
Termination
Eligible Currencies
USD
EUR
GBP
Asset
Haircut
Cash
100%
Treasury < 2y
101%
Treasury (2y-5y)
103%
Treasury(5y-10y)
105%
Treasury(>10y)
108%
GSE
Passthroughs
115%
Corprts/Munis
120%
Methodology 1:
Market factor calculations based on trade specific grid
Regression/interpolation of scenario valuations:
V = V(R,t), R: regression variables
Use regressed/interpolated values on generic grid/scenarios Exposures
Aggregation of market factor exposures with credit/ratings
Methodology 2:
Direct valuations based on trade specific grid: simulation based (such as BGM)
Exposures are obtained for trade specific grid
Interpolate market factor exposures from trade specific grids to generic grid
Methodology 1:
Pros:
Cons:
Accuracy of regression/interpolation: explanatory variables and power
Methodology 2:
Pros:
Cons:
Need to develop a global simulation model
Need consistent correlations among risk factors and for all trades.
Known
Need
dt
dt
dz
dz
dz
Black:
Orange:
Known
dt
dt
dz
dz
Need
Correlation Conserved:
dz
Black:
Orange:
Credit simulation:
Credit Simulation
Methodology 1:
Simulate credit spreads in scenarios
Map credit spreads to ratings credit migrations
Methodology 2:
Structural model simulation using ratings transition matrix
Risk neutralization of transition matrix
Defaults from ratings migration calibrated to market traded CDS
Dynamic
simulation
B
A
AA
AAA
Rating i
Rating k
Rating j
Rating m
p11
p21
~
p
...
p12
...
p22 ...
... ...
0
...
p1n
p2 n
...
p11
p21
~
p
...
p12
...
p22 ...
...
0
t=1
...
...
...
...
1 PnT 0
p12T ...
T
p22
...
...
0
t=T
...
...
p1Tn
T
p2 n
...
1
AAA
AA
BBB
p 1i n 1
i 1
~ p2n
Pt i
...
p i 1
nn
Pd 1 i 1
Pd 2 i 1
...
P i1
dn
0.31%
1.72%
6.28%
0.72%
4.27%
11.80%
2.60%
13.00%
25.60%
10
7.00%
30.00%
48.00%
TMatrix(Annnual)
96.0%
2.50%
1.19%
0.31%
0.40%
83.0%
14.87%
1.73%
0.41%
1.00%
92.3%
6.29%
0.00%
0.00%
0.00%
100%
p 1i n 1
i 1
~ p2n
Pt i
...
p i 1
nn
Pd 1 i 1
Pd 2 i 1
...
P i1
dn
Base Scenario
Market/Credit
Correlation Stress
Correlations
Market Factors
Keeping same market factor exposure
Credit Factors
Solving credit factors incrementally
AAA
AA
BBB
Credit Rating
Collateral
Threshold
AAA
50M
AA
20M
5M
BBB
0M
Credit Rating
Event
BBB
Termination