CREDIT VALUATION ADJUSTMENT
Figure 3: From Passive to Active CRM
Passive Credit Risk Management: Counterparty assessment, limit setting, deal approval
Credit Risk Adjusted Mark-to-Market Valuations (FAS 157, IAS 39)
Pre-deal Credit Charges and Reserves at the counterparty level
Proactive Credit Risk Management: CVA Desks actively manage counterparty risk at portfolio level
Source: NQuantX, LLC
sum of the individual deal CVA, and therefore we need to aggregate the individual deals in a portfolio.
evaluated on an stand-alone basis. However, if the deal is nettable
against other deals, the portfolio dynamics need to be taken into consideration, and the ‘price’ of counterparty risk can be calculated based on the incremental contribution to the portfolio CVA. That marginal contribution could be positive (portfolio CVA is larger after a new deal is brought in the book) or negative (portfolio CVA decreases when we bring a new deal in the book), which effectively means that certain potential new deals could be priced at a discount from a portfolio perspective after taking credit risk into consideration. The CVA desk can also play an
At the heart of the credit revolution is the concept of pricing and hedging credit risk, in which CVA plays a critical role
To allocate and charge the CVA
across business units and traders, netting and collateral clauses play a key role. For example, pricing a non-nettable deal is relatively straightforward, as the deal can be
active role by encouraging traders to use collateral to minimize credit exposures as well as trade with certain counterparties. In order to do so, they need to have the ability to calculate credit risk on an aggregate portfolio from multiple potential trades as well as to determine credit charges, pricing, hedging and reserves from those hypothetical trades. Credit reserves are similar to the payment of an insurance premium against credit
Figure 4: Steps to Calculate CVA in a Simulation Framework
1. Generate Spot and Forward Curve Scenarios for multiple time steps 2. Revalue Deals for each scenario time step
events. Depending on the magnitude, liquidity and duration of the exposure, the credit risk mitigation tools in place (netting, collateral, guarantees ...), as well as the creditworthiness of the counterparty, the credit risk department can establish a set of charges. CVA traders often purchase protection in the Credit Default Swap market. For most trading firms, the largest exposures are often with highly capitalized counterparties with active CDS markets. CVA desks can purchase CDS based on the current and expected exposures. For those counterparties where the
3. Apply Netting Rules at the Counterparty Level for each scenario time step 4. Determine Collateral flows for each scenario time step 5. Repeat Process for multiple scenarios 6. Calculate exposure profile metrics (EPE, PFF...)
7. Calculate Credit Valuation Adjustment at the Counterparty Level Source: NQuantX, LLC 68 December 2010
CDS market is not liquid enough, the CVA desk may need to enter into proxy hedges such as shorting the bonds of the counterparty. In those situations, the CVA desk may need to charge an additional premium for the incremental credit risk incurred by the firm.
Technology Solutions Pricing, hedging and managing
counterparty risk requires a robust and scaleable technology infrastructure that can manage and reconcile market data, deal information and counterparty
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