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2015 | Buch

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XVA Desks — A New Era for Risk Management

Understanding, Building and Managing Counterparty, Funding and Capital Risk

verfasst von: Ignacio Ruiz

Verlag: Palgrave Macmillan UK

Buchreihe : Applied Quantitative Finance

Enthalten in: Springer Professional "Wirtschaft+Technik" , Springer Professional "Wirtschaft"

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Über dieses Buch

Written by a practitioner with years working in CVA, FVA and DVA this is a thorough, practical guide to a topic at the very core of the derivatives industry. It takes readers through all aspects of counterparty credit risk management and the business cycle of CVA, DVA and FVA, focusing on risk management, pricing considerations and implementation.

Inhaltsverzeichnis

Frontmatter

The Context

Frontmatter

1. The Banking Industry, OTC Derivatives and the New XVA Challenge

Abstract

Before going into the details of the XVA world, we want to understand where it fits in the whole financial and banking system In this chapter, we are going to see the basics of how banks work and operate, where the world of derivatives fits in and what is XVA to that world.

Ignacio Ruiz

Quantitative Fundamentals

Frontmatter

2. The Roots of Counterparty Credit Risk

Abstract

For many years, the main focus of risk in books on financial derivatives was Market Risk Market Risk assesses the risk in the trading portfolio resulting from changes in the market prices An example would be: if we were short on an equity forward, the value of that forward will decrease if the underlying equity price increases Market risk metrics deal with short time horizons, typically ten business days, because it is perceived that we can rehedge or exit our positions in only a few days.

Ignacio Ruiz

3. Exposure Measurement for Uncollateralised Portfolios

Abstract

Let’s start our review of exposure measurement with the most popular method: Brownian Monte Carlo.

Ignacio Ruiz

4. Exposure Measurement for Collateralised Portfolios

Abstract

So far we have discussed how to model the exposure of a portfolio without any collateral, but we have seen that most of the netting sets these days are collateralised In this section we will discuss how to account for collateral when calculating exposure metrics.

Ignacio Ruiz

5. Exposure Allocation

Abstract

Up to this point, we have considered exposure calculation for a portfolio, but a question that arises very naturally is how much each trade contributes to the overall exposure.

Ignacio Ruiz

6. Proxies for Exposure Measurement

Abstract

So far we have seen how to calculate exposures when we have sufficient time and computational capability However, often that is not the case The typical problems that we may face include not having access to a Monte Carlo simulation engine, slow pricers,¹ lack of a collateral algorithm in the Monte Carlo engine, etc.

Ignacio Ruiz

7. Default Probability, Loss Given Default, and Credit Portfolio Models

Abstract

We have seen that counterparty credit risk calculations have, mainly, three components: first we need to estimate what the probability is of a given counterparty defaulting This number is usually referred to as the “PD” of the counterparty Then, we need to estimate how much we can be owed if a given counterparty defaults, the Exposure at Default (EaD) We have seen in previous chapters that there are different metrics for this, the most popular being the Expected Positive Exposure and the Potential Future Exposure.¹ Finally, we want to have a view as to how much of the whole amount that we are owed in a default we will actually be lost This is typically called the Loss Given Default (LGD), which is expressed as a percentage of the total amount owed in a default.

Ignacio Ruiz

8. Pricing Counterparty Credit Risk

Abstract

Until 2008, counterparty credit risk in books of OTC derivatives was seen as a secondary risk This was for a number of reasons Most counterparties had strong credit ratings and the world economy was going through a phase of low defaults As a result, the risk of counterparties defaulting was seen as negligible Also, the complexity of pricing, managing, and hedging counterparty credit risk was unparalleled to any other task that financial institutions had faced until then; the farm-computing technology needed for the calculations was only starting to flourish In parallel to this, banks were facing a very competitive market environment, where innovation in the OTC world was seen as key to success Putting all this together, financial institutions had little incentive to invest very large amounts into a risk that was seen as small, difficult to compute, and expensive to manage.

Ignacio Ruiz

9. Regulatory Capital

Abstract

In the aftermath of the 2008 market events, governments changed quite deeply the way they see and regulate financial institutions Until then, the general idea was that of “light touch” regulation, which means that the governments and regulatory bodies effectively let banks self-regulate and their function was, in practice, little more than a supervision of that self-regulation In 2008/09 the interbank money market dried out, nearly all important banks approached a dangerous cliff, and some fell Governments had to step in as, otherwise, the risk-hedging and deposit-credit cycle that lubricate and feed the global economy would have collapsed, with unthinkable consequences to everyone’s life Those events made it clear to governments that there were a number of financial institutions that were too big to fail If they (governments) were, de facto, the last loss absorbers in the financial system, if they were in charge of running the economy and if they wanted to protect the tax payer’s money, many thought that they should have an important input into how financial institutions are risk-managed As a result, a new era of “tight” regulation started.

Ignacio Ruiz

10. Right and Wrong Way Risk

Abstract

Right and wrong way risk can be an important source of counterparty risk in financial institutions In spite of that, it must be said that this risk tends to be poorly managed in many financial institutions One of the reasons being that it has been regarded as very intense both from a methodology and systems point of view.

Ignacio Ruiz

The XVA Challenge

Frontmatter

11. CVA Desk, a Bilateral Dance

Abstract

We have seen that CVA is the present value of the default risk embedded in OTC derivatives The role of the CVA desk is to manage that risk.

Ignacio Ruiz

12. FVA Desk, the Effect of Funding

Abstract

In 2012, Hull and White published a paper in Risk Magazine [43] that shook the quantitative community in investment banks Since 2008, banks have suffered a notable increase in their funding costs, and hence derivative dealers have been calculating this cost and subtracting it from valuations of derivatives However, the theorists (i.e., Hull and White and those that share their view) refute this approach, since “it can create arbitrage opportunities”, and insist that funding should not be accounted for when pricing a derivative Furthermore, they say, a Funding Value Adjustment (FVA) carries double-counting with DVA, the “funding” side of CVA, and as a result the valuation of a bank’s balance sheet with bilateral CVA already accounts for the funding risk the firm has The practitioners have responded by asserting that they must account for the actual costs when valuing a trade, and funding is an important cost not fully captured in the ideal assumptions of bilateral CVA calculations.

Ignacio Ruiz

13. Calculating and Managing FVA

Abstract

In Chapter 12 we have seen the idea behind Funding Value Adjustments: its sources, why and when it should be used Let’s see now how we can compute FVA.

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14. KVA Desk, Capital Management, and RAROC

Abstract

In this book we have discussed many functions of financial institutions that have changed profoundly as a consequence of the 2008 market events Capital calculation and management is another of those areas that is undergoing a deep transformation.

Ignacio Ruiz

15. XVA Desks: A New Era for Risk Management

Abstract

In Chapter 1 we saw how risk management is at the very core of the financial industry The past is full of examples of many years of value creation being destroyed in very short periods of time as a result of poor risk management standards The most clear example of such events happened in 2008, when the whole financial industry was brought down to its knees Governments had to intervene to prevent the major collapse of the economy that would have followed a collapse of the interbank financial system.

Ignacio Ruiz

Further to XVA

Frontmatter

16. Model Risk Management

Abstract

In 2011, the Federal Reserve issued a letter on the topic of Supervisory Guidance on Model Risk Management [64] that established a new setting stone in the field Up to the financial turmoil, model risk was all about checking the accuracy of a model, the so-called “model validation”; however, several model failures during the turbulent years highlighted the need for a broader approach to the problem: “model risk” is now seen as a source of risk that deserves complete focused attention.

Ignacio Ruiz

17. Backtesting Risk Models

Abstract

One of the most important changes in the financial industry since the 2008 market events is the change in stance by governments, from a “loose” regulatory environment to a much more hands-on approach In particular, national regulators have substantially increased their scrutiny over the models used by banks to calculate risk and capital Also, the amount of capital that banks need to hold against their balance sheet has increased substantially and, hence, the cost-benefit balance of investing in good accurate models has shifted importantly towards better models.

Ignacio Ruiz

18. Systems and Project Management

Abstract

In this book we have dealt with the subject of counterparty and funding risk, and related topics We have covered how to model it, and how to manage it.

Ignacio Ruiz

19. Central Clearing and the Future of Derivatives

Abstract

We have seen in this book that the financial industry in general, and the market of derivatives, is changing profoundly This process should be welcome as, if managed well, it can create a very solid banking sector, which is one of the most important pillars of modern societies However, as in every transformation, it must be handled with care too, to avoid creating the seeds for other problems in the future.

Ignacio Ruiz

Backmatter

Titel: XVA Desks — A New Era for Risk Management
verfasst von: Ignacio Ruiz
Verlag: Palgrave Macmillan UK
Electronic ISBN: 978-1-137-44820-0
Print ISBN: 978-1-349-68622-3
DOI: https://doi.org/10.1057/9781137448200