Credit Valuation Adjustments

1
Credit Valuation Adjustments

• Some Risk Management and Measurement Issues from
  a Regulatory Perspective
• Dr. Colin Lawrence and Dr. Nat Benjamin
• Prudential Risk Division, Financial Services
  Authority, UK
• ASIAN BANKER RISK SUMMIT, 8th APRIL, 2011.

2
The CVA Session

• Recent proposed changes to the capital charges
  on CVA have stirred up a storm in the banking
  community. Is this sufficient for banks to reduce
  counterparty risks in Asia? To what extent will
  the changes improve consistency across the banks
  in Asia?
•  

3
Why CVAs are necessary?

• Take a step back CVA is necessary
• To value derivatives correctly and transparently
  and therefore risk-manage them properly
• To recognise losses progressively without waiting
  for default blow-up and spooking the market with
  huge bullet loss
• To note many banks in the Far East are not
  calculating CVA at all. This is bad. It means
  they actually fail any fundamental compliance
  test.
• Objective is not to punish banks but Fair Value
  Counterparty Credit Risk

4
The Justification of a CVA Approach to Capital
Charges

• Increase in counterparty risk during the crisis
  led to huge CVA losses, in particular for
  monolines. This risk was completely missing from
  the rules, so CVA capital charge in Basel 3 was
  indispensible
• Basel 3 CVA charge is not just about higher
  capital, but also incentivising proper
  counterparty risk management, e.g. Hedging
  especially using collateral, netting and master
  agreements.
• Basel 3 CVA charge is VaR-based consistent with
  the MtM nature of CVA volatility risk
• The CVA charge correctly penalises potentially
  inappropriate CVA hedging, whereby CVA desks
  increase positions in underlying derivatives to
  offset CVA volatility this just increases the
  underlying economic risk in the balance sheet and
  can destabilise markets (more on this in the
  slides).
• Use of uniform, consistent CVA capital charge
  across banks makes the capital cost of
  derivatives uniform across banks, and hence
  improves consistency

5
Definition CVA

• Downward adjustment to the valuation of OTC
  derivatives to reflect counterparty risk into
  their fair value.
• Calculated as price of counterparty risk, and
  hence the present value of expected future
  counterparty losses on the netting sets concerned

6
Definition CVA

• Based on term structure of the expected exposure
  to the counterparty, reflecting netting rules and
  projected values of instruments in the netting
  sets.

7
Materiality

• During the last crisis, counterparty losses were
  mostly incurred through CVA rather than actual
  defaults. The creditworthiness of counterparties
  deteriorated, their spreads increased and this
  impacted negatively the fair value of derivative
  transactions passed with them despite the fact
  that few defaulted.
• Very substantial losses were incurred during the
  crisis due to CVA, in particular in situations of
  wrong-way risk as in the case of exposures to
  financial guarantors (monolines). For some firms
  this constituted a major portion of overall
  trading losses.
• Materiality up to several billions of losses,
  sometimes in short timeframes, especially for
  banks with monoline exposures
• CVA losses by themselves constituted 24 of
  losses aggregated across the 10 largest UK
  regulated banks between January 2007 and March
  2009.

8
CVA Risk Management Practices

• Many large firms have set up CVA desk, with
  mandate to hedge CVA volatility.
• Counterparty risk transferred from derivatives
  desks to CVA desk.
• The CVA desk is often managed like any other
  trading desk, with its trading VaR and limits.

Bank
Change in fair value
Change in CVA
CVA Desk
Trading Desk
Counterparty
Change in CVA hedge value
CVA Hedge provider
Natural CVA hedging instruments

• CDSs to offset CVA volatility due to a changes in
  the creditworthiness of the counterparty.
• IR swaps, FX forwards, etc. to offset CVA
  volatility due to changes in counterparty
  exposure.

9
CVA Risk Management Practices

• Treating CVA as a standalone complex instrument
  undesirable consequences.
• Huge basis risks linked to time horizon, pricing,
  basis risk and measurment.
• Building up hedge positions with same
  sensitivities as underlying derivatives offsets
  CVA volatility, but increases the overall
  economic risk on the balance sheet.
• Can destabilize markets 2010 Euro crisis,
  volatility higher at long end of IR swap curve,
  exacerbated artificially by CVA hedging
  activities. Self-exciting process.

10
Conclusions

• Partial equilibrium delta type hedging can lead
  to even overall greater exposure. Doubling up of
  same position!
• DE FACTO YOU ARE HEDGING A STRIP OF CONTINGENT
  RISK FACTOR DIGITALS. MASSIVE CONVEXITY EXPOSURE.
  AND ADDING MORE COUNTERPARTY RISK
• The actual hedge is often not appropriately
  hedged.
• In fast paced trading world illiquidity is
  ignored and convexity shifts in Pds not accounted
  for
• Capital requirements must be placed on overall
  positions not on narrow delta hedging
• CVAs needs to undergo stringent product control
  and valuation uncertainty scrutinise
• Regulation will continue looking at the entire
  exposure which includes all aspects of the trade,
  the counterparty, the booking of the trade and he
  balance sheet.
• CVA is necessary to incentivise appropriate
  pricing of risk and optimal hedging of this risk
  especially with collateral managment . DONT GET
  RID OF IT!

11
CVA Risk Management Practices
Typical basis risk and hedge mismatches

• Use of non-credit-related instruments (e.g. IR
  swaps) to hedge CVA spread sensitivity.
• Use of proxies (e.g. index CDSs) to hedge
  single-name spread sensitivity.

• In addition, CVA hedging strategies often do not
  take account of the credit risk nature of CVA,
  and CVA desks can tend to take positions in any
  instrument whose sensitivity to a risk factor
  offsets that of CVA.
• Example positions in interest rate swaps to
  offset CVA spread sensitivities. Risk management
  practice disconnected from the analysis of true
  economic risk.
• CVA risk measurement and hedging strategy should
  be based on the entire fair value of the
  derivatives, not just a portion of it.
• Need to articulate suitable sequencing order when
  looking to offset CVA sensitivities and lay out
  the types of instrument that provide a sound
  economic hedge to each sensitivity.