LVA, FVA, CVA, DVA impacts on

derivatives management
Christophe MICHEL
Head of RCCAD Quantitative Research

AFGAP-PRMIA April 5th 2012

Contents
02
13
19
26
31

Introduction to LVA
Introduction to CVA
Impact of CSA on CVA
A New Pricing Framework
Centralized Risk Management

Introduction to LVA

Pricing principle

Discounting Forecasted Flows

To make a long story short, pricing is a question of forecasting future fixed, floating or conditional flows in a
given currency and discounting them consistently with a funding level in this currency (in order to avoid
arbitrage opportunities).
For a single flow we can formally write:

Time t value of the future flow

in a given currency

Vt f B f t , T Ft

Time t forecasted value of the future flow

in the given currency

Time t value of a unit of currency paid at T

According to a funding level

Collateral Impact
In case of collateral agreement, additional flows are to be taken into account in the valuation process.
Indeed, to be posted a collateral has to be funded and remunerated with the funding rate, on the other hand,
the collateral posted is remunerated with a given collateral rate described within the collateral agreement.
The additional flows are all differentials of interest generated by the difference between funding and
collateral rates applied to the collateral amount posted.
These additional flows have to be funded and their price is straightforward as soon as we know their forecasted
value.

Valuation of Collateral Impact

Collateral Impact Value: an Implicit Problem

Coming back on the case of a single flow, additional flows linked to a collateral agreement depend upon the
collateral amount paid at each period:

t3
t0

t1

t2

Collateral-linked flow paid at t4 equal to

the differential of interest of collateral
Remuneration posted at t3 :

t4

t5

t6
Future derivative value

C t3 rf t3 rc t3 3

In general, the collateral amount to be posted is directly deduced from the value of the collateralized
derivative i.e. including additional interest flows, say Vc, which is different from the value of the unsecured
derivative (Vf).
Hence, the value of a collateralized derivative depends upon this value: were facing an implicit problem.

Valuation of Collateral Impact: the Standard Case

Collateral Impact Value: the Special Case of Bilateral Contracts

In case of bilateral collateral agreement, we have:

C t Vt c
In this special case, under model assumptions, one can show that the price of a collateralised contract is
obtained by discounting with the collateral remuneration rate instead of the funding rate.
For a single flow, we can formally write:
Time t value of the future flow in a given
Currency including collateral
additionaml flows

Vt c Bc t , T Ft

Time t forecasted value of the future flow

in the given currency

Time t value of a unit of currency paid at T

according to the collateral remuneration rate
Note that in this case, the value of the collateralized contract doesnt depend any more upon the
funding rate.
Note also that if a given derivative pays flows in a given currency but is collateralized in another currency
then its collateralized value will depend upon FX-Term Changes.

Valuation of Collateral Impact: the General Case

General Collateral
Many other possibilities exist in practice. For instance the unilateral collateral agreement can be written as
follows:

Vt c if the MtM of the collateralized portfolio is positive

Ct

0 else

In this case, the collateral impact remains implicit but cannot be explicitly solved like in the standard case.

Pricing Method
To treat the general case, one has to solve a high dimensional optimal control problem.
This is generally not do-able in practice but it is well approximated by Monte Carlo simulation method
Market data are diffused on simulated paths
On each node of the simulation the Mark-to-Market of each product included in the collateral agreement are approximated
The collateral amount to be posted on each node can then be deduced
Additional flows resulting from collateral agreement can then be evaluated on each node
The average of their present value approximate the LVA impact

Note that the collateral impact crucially depends upon the global portfolio within the collateral contract
and cannot be treated on a stand alone basis. A contribution to the global adjustment can be computed.

Before the crisis

Pre-crisis
Bor rates were market convention for discounting all trades, independently on the counterparty, CSA, etc
Implicit assumptions
If the counterparty was uncollateralised, CA-CIB could lend/borrow (unsecured) @ Bor flat
If the counterparty was collateralised, it meant the interest paid on the collateral posted/received was Bor (which is consistent with
interest - mainly OIS as defined in the CSA)

Historically
Access to liquidity was taken as granted

EONIA, 3m Euribor 6m Euribor: historical values*

Basis were tight

These assumptions were
verified

Source: Bloomberg

The IR pricing framework was a SINGLE CURVE one based on -Bor.

During and post crisis

During and post crisis

Liquidity crisis
Drying up of lending/borrowing between banks
Creditworthiness of banks questioned

Pre-crisis funding assumptions no longer hold

Unsecured funding much more expensive
Interest paid on collateral (usually OIS) significantly diverged from Bor rates

EONIA, 3m Euribor 6m Euribor: historical values*

3M EONIA/Euribor spread (LHS)

5Y 3m EONIA/Euribor basis (LHS)
5Y 3m/6m Euribor basis (RHS)

Growing importance of Credit Support Annex (CSA)

Liquidity & credit risk issues are more and more actively managed by banks.
The main trend is a clear shift towards growing use of CSA as collateralization remains among the most
widely used methods to mitigate counterparty credit risk in the OTC derivatives market.
Growth of value of total collateral (USD billions)

Source: ISDA Margin Survey 2011

Growth of collateral agreements

10

Credit Support Annex (1/3)

11

Each CSA determines the collateralization terms between counterparties: bilateral or

unilateral, type of collateral, currency, haircut, threshold, minimum transfer amount and all
other details are stipulated in the CSA. The amount of margin posted and the margin interest
and consequently the valuation of the structure will depend on the CSA terms.

CSA determines the range of assets that may be posted as a

collateral cash in different currencies, government bonds or
corporate or mortgage backed securities

The threshold level will determine how much of the exposure is

collateralized. Margin transfers will be made only if the minimum
transfer amount is exceeded.

The choice of collateral currency will alter the expected

return as the cash funding terms are tied to the corresponding
currencys overnight rate (need of cross currency swap if the
collateral currency is not the same as the deal currency)
For cash-only CSAs, the funding curve corresponds to the
specified collateral interest rate

Bilateral CSA collateral profile

Counterparty posts collateral and receives interest

+
PV
Bank posts collateral and receives interest

Credit Support Annex (2/3)

Description of the CSA

Margin transfer form

Unilateral only one way transfers CA CIB posts a collateral but the counterparty dos not (required by some
supranational entities )
Bilateral symmetric transfer terms

Margin call frequency

Daily margin call is frequency required (becoming a market standard). Longer than daily margin call frequency can
be practical for markets and assets that are not volatile

Threshold
This is the exposure amount below which collateral is not required (the threshold represents an amount of
uncollateralized exposure). A threshold of zero implies that any exposure is collateralized

Minimum transfer amount

The smallest amount of collateral that can be transferred.
It is used to avoid the workload associated with a frequent transfer of insignificant amounts of collateral

12

Credit Support Annex (3/3)

13

What is a standard CSA ? Pay attention to the detail when negotiating CSA terms

Standard CSA terms

Bilateral margin transfer form: symmetric transfer

terms for both parties
Daily margin call frequency (weekly can be also
accepted as standard)
No threshold up to 5M threshold is considered as
reasonable
Cash and G7 bonds (haircuts 0%-2% on short
term maturities and 5-10% on longer term maturities)
In EUR or in USD, remunerated at EONIA FLAT or
Fed Funds FLAT

Non standard agreements

No CSA
Unilateral CSA (can be unilateral in our favour; often
supranational institutions require an unilateral CSA in their
favour)
CSA with very high threshold 50-100M threshold will
impact pricing
CSA with rating triggers (example: CA-CIB needed to
post an independent amount to EIB due to the S&P rating
action)
Sub-optimal CSAs negative spreads on cash collateral,
securities received that cant be re-hypothecated

Introduction to CVA

CVA Basics Definition

15

To be or not to be paid ?
The Credit Value Adjustment appears in the pricing framework when a credit risk is taken into account.
Formally, one can explicit this risk by multiplying each payment flow by the following function:

1 if the flow is actually paid at T

0 if the flow isn' t paid at all

FT a flow paid at T becomes FT

In case of a counterparty default at time T, the key question is to measure the exposure.
A priori, the exposure is the sum of all positive mark to market of each transaction remaining at time T
with this counterparty.
In case of netting agreement with the counterparty, the exposure becomes the sum of all netted positive
mark to market of each set of transactions within each netting agreement contract.

A classical formula
A classical CVA formula can be expressed as Maturity
the amount of discounted future Expected Losses

CVA LGD *

t 0

Loss Given Default

PDt 1,t * EPEt * DFt

Default Probability

Exposure at Default (Discounted)

CVA Basics Key Ingredients

16

Expected Positive Exposure (EPE)

Calculated via simulations process (Monte Carlo)
Computation including netting and collateral agreements
Involves only the Positive Exposures in case of Counterparty Default
Definition of Exposure linked to the mark to market of transaction
Evaluated Contingent on the default of the counterparty

including right way / wrong way risks

CSA or break clause have a huge impact on EPE

Market CDS Curve

Default Probability
Implied from CDS spreads (market-implied) or,
Historical default probabilities

Loss Given Default / Recovery Rate

Market Implied (where possible) : LGDMarket
Internal Recovery measure : LGDInternal

CVA Basics Key Ingredients

17

Risk parameters:
Peak Exposure: Maximum of the MtM of the transaction over its lifespan, given a high confidence level (VaR
95%)
Loan Equivalent: Average EPE over time (measure to determine risk equivalent in terms of loan for economic
capital calculation)
Tail Credit Risk (CVaR): average of 5% maximum potential losses
10y
10yEUR
EURIRS
IRSCA-CIB
CA-CIBReceives
ReceivesFixed
Fixed2.3%
2.3%

CVA Basics Interpretation

CVA as an Accounting Provision
Measure of Expected Loss
Use of Historical Default Probabilities
Inactive Risk Management (Acceptance to carry the Credit Risk)
No Market Hedges in Place (IR, FX or Credit)

Credit Risk remains in the individual traders books

CVA as a Mark to Market Adjustment
Market Cost of Dynamically Hedging Counterparty Risk
Use of Market Implied Default Probabilities (implied from CDS)
Active Risk Management Strategy in place
Local Sensitivities
Jump to Default Risks
Concentrations / Wrong Way risks
Market Hedges in place (IR, FX and Credit)
Credit Risk transferred to a centralised CVA desk

18

CVA Basics Summary

CVA is a fair market adjustment to the derivatives portfolio
CVA charges are there to offset losses in the global CVA portfolio due to new trades
Incremental impact on the portfolio
CVA P&L is flat provided the cash transfers take place

CVA hedges are initiated in order to offset future CVA P&L volatility for CA-CIB
Due to portfolio MTM movements (IR, FX, Credit Hedges)
Due to counterparty CDS Spread Changes (Credit Hedges)
At inception: CVA P&L is flat, Hedge P&L is flat:
1. CDS spreads increase: CVA increases (Loss) versus Hedge P&L (Gain)
2. CDS spreads decrease: CVA decrease (Gain) versus Hedge P&L (Loss)
3. CDS spreads stay static: Negative carry on Hedge (Loss) is offset against positive carry of CVA (Gain)

CVA Credit Hedges also provide

Jump to default risk management
Basel III capital reductions

Debit Value Adjustment (DVA) is the CVA seen from the counterparty. To take it into account allows symmetrical
views on the shared portfolio.

19

Impact of CSA on CVA

CVA impact of collateral on stand alone transaction (IRS)

The Credit Support Annex is a key tool for credit risk mitigation
EPE computation includes netting and collateral agreements
EPE is calculated up to the threshold
Above threshold, mark to market drift is calculated on margin call period + collateral lag period (10days)

CSA features are built into EPE simulations and consequently have an impact on CVA

Collateral features

Trade description
Start date:

10 Apr 2012

Unilateral vs Bilateral

Maturity:

10Y

Threshold

Notional:

EUR 100M

Frequency

CA-CIB receives:

2.30% (SA, act/360)

Currency

CA-CIB pays:

6M Euribor (SA, 30/360

Minimum Transfer Amount (MTA)

Counterpart:

XXX

5Y cds:

143bps

Internal rating:

21

CVA impact of collateral on stand alone transaction (IRS)

No collateral agreement in place

Peak exposure:

9 508 071

Market CVA:

137 124 (1.49 bps p.a)

Historical CVA:

9 942

Risk exposure is maximal for CA-CIB

(0.11 bps p.a)

Market CVA ~ hedging cost of loan lquivalent on cds market

CSA agreement in place

Sharp decrease of risk profile due to CSA risk mitigation

CSA in place

Threshold: 0

Bilateral

MTA: 0

Frequency: daily

Currency: EUR

Peak exposure:

1 378 356

Market CVA:

27 948 (0.30 bps p.a)

Historical CVA:

1 850

(0.02 bps p.a)

22

CVA impact of collateral on stand alone transaction (IRS)

CSA agreement in place
CSA in place

Threshold: 0

Bilateral

MTA: 0

Frequency: weekly

Currency: EUR

Peak exposure:

1 704 987

Market CVA:

33 938

(0.37 bps p.a)

Historical CVA:

2 252

(0.02 bps p.a)

CSA agreement in place

CSA in place

Threshold: 0

Bilateral

MTA: 0

Frequency: daily

Currency: EUR

Peak exposure:

1 378 356

Market CVA:

27 948 (0.30 bps p.a)

Historical CVA:

1 850

(0.02 bps p.a)

Weekly frequency: drift is computed on one week +

10 days collateral lag

23

CVA impact of collateral on stand alone transaction (IRS)

CSA agreement in place
CSA in place

Threshold: 500K

Bilateral

MTA: 0

Frequency: daily

Currency: EUR

Peak exposure:

1 878 356

Market CVA:

43 346 (0.47 bps p.a)

Historical CVA:

3 263 (0.024 bps p.a)

CSA agreement in place

CSA in place

Threshold: 0

Bilateral

MTA: 0

Frequency: daily

Currency: EUR

Peak exposure:

1 378 356

Market CVA:

27 948 (0.30 bps p.a)

Historical CVA:

1 850

(0.020 bps p.a)

24

CVA impact of collateral on stand alone transaction (CRS)

Collateral features

Trade description
Start date:

10 Apr 2012

Maturity:

10Y

Unilateral vs Bilateral

Notional:

EUR 100M

Threshold

EURUSD:

1.3091

Frequency

CA-CIB pays:

6M Euribor (SA, act/360)

Currency

CA-CIB receives:

USD 2.25% (SA, act/360)

Minimum Transfer Amount (MTA)

Notional exchange:

Beg and end

Counterparty
Name:

XXX

5Y cds:

143bps

Internal rating:

25

CVA impact of collateral on stand alone transaction (CRS)

26

Risk exposure is maximal for CA-CIB

No collateral agreement in place

Peak exposure:

94 738 968

Market CVA:

1 718 224

(18bps p.a)

Historical CVA:

192 376

(2 bps p.a)

CSA agreement in place

CSA in place

Threshold: 0

Bilateral

MTA: 0

Frequency: daily

Currency: EUR

Peak exposure:

4 181 994

Market CVA:

227 864

(2.40 bps p.a)

Historical CVA:

22 381

(0.24 bps p.a)

CSA drastically minimizes risk exposure on cross-currency

A new pricing framework

Collecting Information
Market Information
In the new pricing framework, market prices remain of course a central source of information but one has to
interpret them consistently.
A price is at least dependent with the CSA of the product priced and when one observe the price of an OTC
product on a screen the question of the implicit CSA of this price has to be solved.
To fix this problem, a standardization of market practice arise
Standard swap are assumed cleared with a collateral in the currency of the swap with a collateral remuneration at
OIS rate.
Multi-currency products are often assumed collateralized in USD with a collateral remuneration at USDOIS rate.
Physical settlement swaption quotation often assumes the underlying swap to be a standard swap and quotes a
forward premium in order to avoid the LVA impact on the discounted premium.

Once the implicit CSA question is answered, it becomes possible to strip from market prices cleaned
market data (IR curves per tenor, FX forward, default probabilities, inflation forward, liquid volatilities, etc)

Additional Observable Information

Our own funding level will also intervene in the new pricing framework even if its monetisation isnt
straightforward.
From the CVA point of view, some new deal information are to be taken into account like break clause.
Lastly, the main new information type to input and which will impact all quotations is all information related
to the client (CSA, netting agreement, rating, )

28

Forecasting Data
Diffusion Data
In addition to market data and client data, we have seen that most of xVA are linked to global portfolio
measures based on Monte Carlo simulations.
Once the diffusion model is defined, its calibration can partly be implicit (calibration on a set of market
prices) but will mainly linked to historical market behaviour.
Like for any diffusion model design for structured derivatives pricing, the calibration process is dependent
with the sophistication of the diffusion process (from a theoretical point of view) and availability of implicit
and historical information.
A key point to focus on is the joint behaviour between all class of market risks (lets say correlation to
simplify) implicitly defined in the diffusion process. It is indeed well known that this point will drive market risk
netting from the global portfolio point of view.

Missing Credit Data

For a great number of counterparties there is no quoted CDS.
The CVA needs information on default probabilities and LGD for any counterparty. This information is to be
forecasted.
Based on all internal works on counterparty risk management (sector classification, internal ratings,
historical recovery rates, ), it becomes possible to map any counterparty on market information.

29

Stand alone Price + Portfolio-Linked Adjustment

30

The new pricing workflow can be summarized as follows:

By definition, the stand alone price of a product is its value independent with the portfolio of deals
Calculation Engines
Stripping
under CSA
assumptions

Raw
Market Data

Cleaned
Market Data

Internal
Client
Portfolio

Internal
Client
Data

Data Forecasting
Engine

Global Simulation
Engine
Bilateral
Bilateral
CSA
CSAInput
Input

++

Product Description
(Termsheet)
Client

t0

t1

t2

t3

t4

Portfolio
Portfolioadjustment
adjustment
(CVA,
DVA,
(CVA, DVA,FVA,
FVA,
non
standard
non standardLVA)
LVA)

t5

t6

Stand-Alone
Pricing Engine

Stand
Standalone
alonePrice
Price

About Portfolio-Linked Adjustments

A Non Linear Adjustment
Generally speaking, portfolio-linked adjustments arent linear i.e. the value adjustment of a given deal
depends upon the portfolio (and market data) at the moment the valuation.
Same trade with two counterparties, with different credit profiles or portfolio vis--vis the bank, will have
different market prices.
Example: Client receives Fixed on 10y Swap
Mid Market 10y Swap Rate = 2.31%

Client 1: Rated A- receives 2.27%

Client 2: Rated B+ receives 2.23%

4bp CVA charge

8bp CVA charge

In practice, an incremental portfolio value adjustment relating to the new trade is used. It corresponds to the
differential of portfolio value adjustment with and without the deal.
This incremental value can either be positive or negative and a pricing policy is to be defined.

Adjustment Breakdown
The global portfolio value adjustment is made with several sources of risks (credit, liquidity, funding) and with
several market data qualities (pure market data versus forecasted data).
To look into these, it is meaningful to evaluate the global portfolio value adjustment breakdown based on
those different sources of risk and data qualities.
Similarly, this breakdown can be computed for incremental portfolio value adjustments at the deal level.

31

Centralized Risk Management

Hedging Risks
Stand-alone Value Risk Management
A priori, the stand-alone product value can be hedged trading desk per trading desk without particular need
of centralisation.
Nevertheless, the multiplicity of CSA may induce not so material additional sources of risks for trading
desks (like cross-currency basis swap margin risks) which can pollute trading desk risk management and
which could be centralised.
We have to keep in mind that any transaction has, from valuation and risk management point of view, a
stand-alone part and a portfolio part. The implicit CSA of the stand-alone part of the deal isnt necessarily
the actual CSA of the deal.

Funding Risk
Funding risk could in theory be managed on a stand-alone basis since this risk isnt explicitly linked to the
portfolio view.
But this risk cant be directly risk managed in the market.
Hence, this risk has to be risk managed jointly with ALM. Indeed, the stake is the remuneration or the
charge of this adjustment. This has to be made consistently with the way these remuneration/charge are
monetised by ALM.
Global simulation tools can of course be very used to obtain a complete view of the distribution of funding
needs at any future maturity (expectation, standard deviations, of funding needs including collateral
simulation).

33

Hedging Risks
Portfolio Adjustment Value Risk Management
By definition, this adjustment has to be centrally risk-managed. Indeed:
The value to risk manage make sense at the portfolio level only.
Global metrics to evaluate (EPE) are time consuming and depend upon a wide range of market data then standard
complete local management is just numerically impossible and alternative risk management strategies has to be
developed.
Some adjustments are based on forecasted/mapped data which as to be specifically risk managed

At the centralized level, impacts of global events like defaults, CSA changes, Funding changes can be
anticipated, studied and quantified.
Conversely, a centralized desk can be pro-active on all portfolio-linked risks:
CSA change
Waives/Further discounted counterparties (to take into account liquidity providers or to be aligned with the Banks
business strategy.
Wrong way / Right way risk.
RWA management

A centralised desk ensure a unique and consistent FO view internally and externally.

34

Capital requirements for Counterparty Credit Risk (CCR)

Basel I
Capital CCR only covers default risk: MtM + standardized add-on based on issuer type, underlying and maturity
No capital requirement for MTM loss due to change in counterparty credit spread

Basel II
Capital CCR only covers default risk
Internal Ratings-Based approach: Internal assessment of default risk via internal probability of default and LGD
No capital requirement for MTM loss due to change in counterparty credit spread
EPE: counterparty exposure estimated using non-stressed market data, on a 1Y horizon

Basel III
Basel III Capital CCR = Capital Default (Basel II) + Capital CVA
Capital CVA: additional Capital requirement for MtM loss due to change in counterparty credit spread
Capital CVA: Market Risk capital charge estimated using stressed VaR on credit instruments
EPE: counterparty exposure estimated under stressed parameters on the full maturity
CVA VaR is calculated Net of Eligible Hedges
Other adjustments:

Assuming a higher correlation between financial institutions in the supervisory formula

Extending the collateral lag period from 10 days to 20 days

35

Regulatory impact on capital requirements

Changing Landscape
CVA VaR now a key component in Return on Capital calculations for New Trades
DVA not an allowable offset under Basel III, so competitors using DVA for pricing must consider capital usage
Active CDS Hedging encouraged Influences CDS pricing and volatility
Innovation needed to help reduce RWA costs
Cost of Novations / Intermediations now closely scrutinised
Need for CVA Pricing Tools to consider Basel III impacts

CVA Capital Methodology linked more closely to Market Dynamics

Regulatory Methodology is entirely Market Based --> No reliance on Historical Default Measures
Basel III extends maturity of Exposure at Default to the Full EPE Profile (previously 1y EPE under Basel II)

Capital Relief provided by Eligible Hedges

Includes Single name CDS, CDS index, CCDS and other hedges that directly reference the Counterparty
Hedging a CVA portfolio releases Capital

Challenge: focus on regulatory influence vs focus on competitive pricing

36

Central Desk Mandate

Centralise and risk manage FO derivatives counterparty and portfolio-linked risk
Minimise xVA P&L impact for FO through:
Systematic Macro hedging of the overall xVA P&L impact
Single Name default hedging (where practical)

Active participation in RWA management

Target business model is to incentivise Sales Force not only on revenue generation but also on RWA and liquidity consumption
Sales recognition methodology has to be consistently defined

Establish a Pricing Policy aligned with the internal xVA methodology

Educate and train sales and support functions in xVA related issues
Involvement in Regulatory Discussions / Decisions affecting xVA
Involvement in ISDA / CSA discussions affecting xVA.
Need to remain Competitive in Pricing
Must remain business-focused and incentivise the right types of trades:
Waiver / Exemption for Target Clients / Businesses
Additional Charge for Wrong Way trades
Benefits for Right Way Trades / Unwinds / Portfolio Diversifications
Need for feedback from clients relating to current market practices
Encourage risk mitigation (eg negotiation of Credit Support Annex (CSA) with counterparties)

37

Interaction with other FO teams

Central Desk is there to Support the Business:
In accurately pricing Credit and Liquidity into new trades, and
To manage the credit risk of derivatives portfolio through dynamic CVA hedging

To achieve this Central Desk needs:

Active Dialogue with Trading / Sales / Structuring on new trades, and existing portfolio (risk reduction opportunities)
Involvement in Complex Trades, especially where replacement costs in default are hard to define
Clear Understanding of all key components of the trades
Identification of potential risk mitigants - break clauses, legal details (CSA, netting), etc
Feedback from Clients !

... and on problem names

To wall cross the CVA team in case non-public information needs to be shared. To check PV details in front/back office systems.
Involve Legal team to ensure appropriate modus operandi is followed

Goal is to streamline process

Revised guidelines for involvement of Central desk in trade analysis (e.g. where CVA > 50k EUR, ... thresholds to be discussed/revised)
Improvement of CVA / LVA pricing tools (including capital costs/usage)
Clear communication is critical

... and to Adapt to Change

Methodology is dynamic and intended to support business initiatives

38

Disclaimer

39

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