Counterparty Credit Risk
James McCann
Director – FX, Rates & Credit
March 2016
REUTERS/Paulo Whitaker
© 2016 Thomson Reuters 2
History of Counterparty Credit Risk
DEFAULTS & FINANCIAL SCANDALS
• Asian Crisis
• Russia & LTCM
COUNTERPARTY CREDIT RISK
• Passive risk management
• Some banks price CVA
• No hedging
BASEL I
• Backward looking – focused on existing
situation rather than future
• No advanced measurement of risk
• Simple tier calculations (Tier 1 Capital
ratio 4%)
1990s 2000s2007 & Beyond
DEFAULTS & FINANCIAL SCANDALS
• Enron
• WorldCom
• Tyco
COUNTERPARTY CREDIT RISK
• Increased focus on CVA
• Improved computing technology
• SFAS157 points to CVA
BASEL II
• Somewhat forward looking – risk-
sensitive approach to capital
• Three-Pillar risk management
DEFAULTS & FINANCIAL SCANDALS
• Lehman
• Banks & Financial Institutions
• Auto Industry
COUNTERPARTY CREDIT RISK
• Accounting standards specify CVA/DVA
• Multi-curve framework
• Central Counterparty Clearing
• xVAs
BASEL III
• Forward looking
• Requirements for higher minimum capital
and capital quality
• Introduced leverage ratios & liquidity risk
© 2016 Thomson Reuters 3
Counterparty Credit Risk
“Counterparty credit risk is the risk arising from the possibility that the
counterparty may default on amounts owned on a derivative transaction.
Derivatives are financial instruments that derive their value from the
performance of assets, interest or currency exchange rates, or indexes. They
may include structured debt obligations and deposits, swaps, futures, options,
caps, floors, collars, and forwards, either singly or in various combinations”
OFFICE OF THE COMPTROLLER OF THE CURRENCY (OCC)
U.S. DEPARTMENT OF THE TREASURY
http://www.occ.treas.gov/topics/credit/commercial-credit/counterparty-credit-risk.html
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Credit Valuation Adjustment (“CVA”)
“CVA is an adjustment to the fair value (or price) of derivative instruments to
account for counterparty credit risk (CCR). Thus, CVA is commonly viewed
as the price of CCR. This price depends on counterparty credit spreads as
well as on the market risk factors that drive derivatives’ values and, therefore,
exposure”
BASEL COMMITTEE ON BANKING SUPERVISION
BANK FOR INTERNATIONAL SETTLEMENTS
http://www.bis.org/bcbs/publ/d325.pdf
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SFAS 157 – “Fair Value Measurements”
“Risk-averse market participants generally seek compensation for bearing the
uncertainty inherent in the cash flows of an asset or liability (risk premium).
A fair value measurement should include a risk premium reflecting the amount market
participants would demand because of the risk (uncertainty) in the cash flows”
“Risk premiums should be reflective of an orderly transaction (that is, not a forced or
distressed sale) between market participants at the measurement date under current
market conditions”
“…the fair value of the liability shall reflect the nonperformance risk relating to that
liability.
Nonperformance risk includes but may not be limited to the reporting entity’s own credit
risk. The reporting entity shall consider the effect of its credit risk (credit standing) on
the fair value of the liability in all periods in which the liability is measured at fair value.”
FINANCIAL ACCOUNTING STANDARDS BOARD
Statement of Financial Accounting Standards No. 157
© 2016 Thomson Reuters 6
Credit Valuation Adjustment (“CVA”)
“Under Basel II, the risk of counterparty default and credit migration risk were
addressed but mark-to-market losses due to credit valuation adjustments
(CVA) were not. During the financial crisis, however, roughly two-thirds of
losses attributed to counterparty credit risk were due to CVA losses and only
about one-third were due to actual defaults”
BASEL COMMITTEE ON BANKING SUPERVISION
BANK FOR INTERNATIONAL SETTLEMENTS
http://www.bis.org/press/p110601.htm
© 2016 Thomson Reuters 7
Derivatives Market
Exchange-traded futures and options
Interest Rate, Dec 2015: 62,950 13%
OTC, interest rate derivatives
H1 2015: 434,740 87%
(in billions of US dollars)
SEMIANNUAL OTC DERIVATIVES STATISTICS
BANK FOR INTERNATIONAL SETTLEMENTS
http://www.bis.org/statistics/d7.pdf
http://www.bis.org/statistics/d2.pdf
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Total Cleared Since Jan 2015: USD 88,143 billion (82%)
http://www.swapsinfo.org/charts/derivatives/price-transaction
Derivatives MarketCleared, USD-denominated, all Interest Rate Derivatives products, all terms
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Total Uncleared Since Jan 2015: USD 18,858 billion (18%)
http://www.swapsinfo.org/charts/derivatives/price-transaction
Derivatives MarketUncleared, USD-denominated, all Interest Rate Derivatives products, all terms
© 2016 Thomson Reuters 10
Derivatives Market
ISDA MARGIN SURVEY
https://www2.isda.org/functional-areas/research/surveys/margin-surveys
Fixed-income derivatives: CSA 88.9% No CSA 11.1%
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Exchange13%
OTC87%
Cleared82%
Uncleared18%
Collateralized88.9%
Uncollateralized11.1%
Derivatives MarketThe Uncollaterialized Interest Rate Derivatives market is a small portion of the overall market
Note: CSA terms not necessarily standard
© 2016 Thomson Reuters 12
The xVAs
CVA
• Adjustment to a derivative price due to risk of a counterparty default
DVA
• Adjustment to a derivative price due to risk of a own default
FVA
• Adjustment to a derivative price due to funding cost/benefit associated with the uncollateralized portion of
derivative portfolios, and in collateralized derivatives where the terms of the agreement do not permit the reuse of
the collateral received
KVA
• Adjustment to a derivative price due to the cost of regulatory capital during the life of the trade
COLVA
• Adjustment due to the optionality inherent in the collateral agreement (ability to choose the currency or type of
collateral to post) and any other non-standard collateral terms
MVA
• Adjustment due to posting initial margin for the life of the trade
© 2016 Thomson Reuters 13
Methods of Calculating CVA
DURATION METHODOLOGY
• CVA = Mark-to-Market x Duration x Credit Spread
• Simple method
• Single trade or on a portfolio basis
• Potential future exposure is not considered
DISCOUNTED CASH FLOW METHODOLOGY
• CVA = Risk-Free “Fair Value” Price - Credit-Adjusted Price
• Discounting curve is adjusted by appropriate credit spread
• Can apply different credit spreads to assets and liabilities
• Relatively simple method for vanilla trade
• Difficult method for portfolios
• Potential future exposure is not considered
Current Exposure methods
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Discount Cash Flows: Fixed Qtrly Money vs 3mLIBORPositive mark-to-market of USD 29,704
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Discount Cash FlowsBoth sets of cash flows discounted at LIBOR flat
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Discount Cash Flows: IRS with L+100bp CounterpartyCash flows received from Counterparty discounted at LIBOR +100bp
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Discount Cash Flows: IRS with L+100bp CounterpartyPositive mark-to-market now USD 27,399, a reduction of USD 2,305
© 2016 Thomson Reuters 18
Discount Cash Flows: IRS with L+100bp CounterpartyDiscounting received cash flows at LIBOR+100bp reduces mark-to-market by USD 2,305
© 2016 Thomson Reuters 19
Methods of Calculating CVA
SWAPTION METHODOLOGY
• 𝐶𝑉𝐴 = 𝐿𝐺𝐷 ×𝑡=1
𝑇
𝐷𝑒𝑓𝑎𝑢𝑙𝑡 𝑃𝑟𝑜𝑏𝑎𝑏𝑖𝑙𝑖𝑡𝑦(𝑡−1,𝑡) × 𝑆𝑤𝑎𝑝𝑡𝑖𝑜𝑛 𝑃𝑟𝑒𝑚𝑖𝑢𝑚𝑡
• Expected Loss = (1-Recovery Rate) x Default Probability x Swaption Value
• CVA = Sum of Expected Losses
• Considers Potential Future Exposure as well as Current Exposure
• Can be applied to assets and liabilities
• Only works for interest rate swaps
• Difficult method for portfolios
Expected Exposure methods
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Swaption Method: IRS with +100bp CounterpartyCredit adjustment of USD 626 assuming a spread of 100bp
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Swaption Method: IRS with +100bp CounterpartyExpected Loss = (1-Recovery Rate) x Default Probability x Swaption Value
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Swaption Method: IRS with +100bp CounterpartyA series of swaptions that correspond to the counterparties cash flows are modeled
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Swaption Method: IRS with +100bp CounterpartyThe CVA is the sum of all the Expected Losses
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Swaption Method: BBB-rated Non-FinancialCDS or Credit Curves can be used that will more accurately reflect the Probabilities of Default for the counterparty
© 2016 Thomson Reuters 25
Swaption Method: BBB-rated Non-FinancialCDS or Credit Curves can be used that will more accurately reflect the Probabilities of Default for the counterparty
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Swaption Method: Fixed Semi Bond vs 3mLIBOR
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Swaption Method: CVA & DVAUsing 100bp Spreads for both Self and Counterparty, the CVA and DVA are not equal
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Swaption Method: CVA & DVAFor CVA the series of swaptions will be quarterly because Counterparty payments are quarterly
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Swaption Method: CVA & DVAFor DVA the series of swaptions will be semi-annually because Self payments are semi-annually – note: higher Def Prob
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Swaption Method: Fixed Qtrly Money vs 3mLIBOR
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Swaption Method: CVA & DVACVA and DVA are not equal despite same Spread and ATM fixed rate
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Swaption Method: CVA & DVAPayer swaptions are used for CVA – the strikes will be 0.9479%, making them all in-the-money so higher value
ATM Fwd
3m 21m 0.9933
6m 18m 1.0317
9m 15m 1.0707
1y 1y 1.1070
15m 9m 1.1414
18m 6m 1.1746
21m 3m 1.2031
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Swaption Method: CVA & DVAReceiver swaptions are used for DVA – the strikes will be 0.9479%, making them all out-of-the-money so lower value
ATM Fwd
3m 21m 0.9933
6m 18m 1.0317
9m 15m 1.0707
1y 1y 1.1070
15m 9m 1.1414
18m 6m 1.1746
21m 3m 1.2031
© 2016 Thomson Reuters 34
Swaption Method: CVA & DVAReceiver swaptions are used for DVA – the strikes will be 0.9479%, making them all out-of-the-money so lower value
ATM Fwd
3m 21m 0.9933
6m 18m 1.0317
9m 15m 1.0707
1y 1y 1.1070
15m 9m 1.1414
18m 6m 1.1746
21m 3m 1.2031
© 2016 Thomson Reuters 35
Methods of Calculating CVA
EXPECTED FUTURE EXPOSURE METHODOLOGY
• 𝐶𝑉𝐴 = 𝐿𝐺𝐷 × ධ0
𝑇𝑑𝐷𝑒𝑓𝑎𝑢𝑙𝑡𝑃𝑟𝑜𝑏𝑎𝑏𝑖𝑙𝑖𝑡𝑦(𝑡) × 𝐸𝑃𝐸(𝑡) × 𝐷𝑖𝑠𝑐𝐹𝑎𝑐𝑡𝑜𝑟(𝑡)
• 𝐶𝑉𝐴 = 𝐿𝐺𝐷 ×𝑡=1
𝑇
𝐷𝑒𝑓𝑎𝑢𝑙𝑡 𝑃𝑟𝑜𝑏𝑎𝑏𝑖𝑙𝑖𝑡𝑦(𝑡) × 𝐸𝑃𝐸(𝑡) × 𝐷𝑖𝑠𝑐𝐹𝑎𝑐𝑡𝑜𝑟(𝑡)
• Considers Potential Future Exposure as well as Current Exposure
• Can be applied to assets and liabilities
• Single trade or on a portfolio basis (including multiple asset classes)
• Requires complex modeling
• Netting and specific Collateral details can be incorporated into the simulation
• Can be costly to implement
Expected Exposure methods
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Cash Flows of Interest Rate Swap
0d 3m 6m 9m 1y 15m 18m 21m 2y
Fixe
d P
aym
en
ts
Flo
atin
g P
aym
en
ts
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Cash Flows of Interest Rate SwapDiscount back to today
0d 3m 6m 9m 1y 15m 18m 21m 2y
Fixe
d P
aym
en
ts
Flo
atin
g P
aym
en
ts
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Remaining Cash Flows of Interest Rate SwapIn 3mths the remaining cash flows will be discounted to then
Note: future discount factors & floating cash flows are unknown
0d 3m 6m 9m 1y 15m 18m 21m 2y
Fixe
d P
aym
en
ts
Flo
atin
g P
aym
en
ts
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Remaining Cash Flows of Interest Rate SwapIn 6mths the remaining cash flows will be discounted to then
Note: future discount factors & floating cash flows are unknown
0d 3m 6m 9m 1y 15m 18m 21m 2y
Fixe
d P
aym
en
ts
Flo
atin
g P
aym
en
ts
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Remaining Cash Flows of Interest Rate SwapIn 18mths the remaining cash flows will be discounted to then
Note: future discount factors & floating cash flows are unknown
0d 3m 6m 9m 1y 15m 18m 21m 2y
Fixe
d P
aym
en
ts
Flo
atin
g P
aym
en
ts
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Mark-to-Market of Interest Rate Swap Over TimeMark-to-Market is net present value of remaining cash flows
0d 3m 6m 9m 1y 15m 18m 21m 2y
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Simulate Multiple ScenariosConsider Positive Exposures
0 2 4 6 8 10
Ne
gati
ve M
tM
P
osi
tive
MtM
EE = Max(MtM,zero)
NEE = Min(MtM,zero)
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0 2 4 6 8 10
Exp
ect
ed
Exp
osu
re
Average the Positive ExposuresExpected Exposure profile quantifies the average value of the potential losses as a function of time
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Expected Future Exposure MethodFor each period, calculate the product of Default Probability, Expected Exposure, Discount Factor and LGD
Calculate the sum of these values
EXPECTED FUTURE EXPOSURE METHODOLOGY
• 𝐶𝑉𝐴 = 𝐿𝐺𝐷 × ධ0
𝑇𝑑𝐷𝑒𝑓𝑎𝑢𝑙𝑡𝑃𝑟𝑜𝑏𝑎𝑏𝑖𝑙𝑖𝑡𝑦(𝑡) × 𝐸𝑃𝐸(𝑡) × 𝐷𝑖𝑠𝑐𝐹𝑎𝑐𝑡𝑜𝑟(𝑡)
• 𝐶𝑉𝐴 = 𝐿𝐺𝐷 ×𝑡=1
𝑇
𝐷𝑒𝑓𝑎𝑢𝑙𝑡 𝑃𝑟𝑜𝑏𝑎𝑏𝑖𝑙𝑖𝑡𝑦(𝑡) × 𝐸𝑃𝐸(𝑡) × 𝐷𝑖𝑠𝑐𝐹𝑎𝑐𝑡𝑜𝑟(𝑡)
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Expected Exposure MethodFixed Semi Bond vs 3mLIBOR
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Expected Exposure Method: Counterparty +100bpFixed Semi Bond vs 3mLIBOR
Exposure determined using a Monte Carlo engine
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Expected Exposure Method: Counterparty +100bpFixed Semi Bond vs 3mLIBOR
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Expected Exposure Method: Positive Mark-to-MarketPositive NPV: USD 234,244
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Expected Exposure Method: Positive Mark-to-MarketExpected Exposure graph reflects positive MtM at inception, with zero exposure by maturity
Negative Exposure (Self) graph begins at zero because positive MtM is ignored
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Expected Exposure Method: Positive Mark-to-MarketCredit-Adjusted NPV: USD 201,254
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Expected Exposure Method: Positive Mark-to-MarketCVA & DVA: Spread +100bp
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Expected Exposure Method: Negative Mark-to-MarketNegative NPV: USD 228,684
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Expected Exposure Method: Negative Mark-to-MarketExpected Exposure graph begins at zero because negative MtM is ignored
Negative Exposure (Self) graph reflected negative MtM at inception with zero exposure by maturity
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Expected Exposure Method: Negative Mark-to-MarketCredit-Adjusted NPV: USD 248,665
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Expected Exposure Method: Negative Mark-to-MarketCVA & DVA: Spread +100bp
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Expected Exposure Method: Pay Fixed 10yr IRSCVA: Spread +100bp
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Expected Exposure Method: Receive Fixed 10yr IRSCVA: Spread +100bp
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Funding Value Adjustment
FUNDING COST ADJUSTMENT (“FCA”)
• Trade with non-CSA counterparty and Hedge with CSA counterparty
• Assume trade between End User and Bank has positive mark-to-market from perspective of Bank, therefore negative MtM on hedge
• No Collateral is posted by the End User but Bank has to post Collateral on the hedge
• If Bank has to post Collateral they will need to fund it
Funding Value Adjustment = Funding Cost Adjustment + Funding Benefit Adjustment
End User Bank Hedge
Post CollateralNo Collateral
OIS
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Funding Value Adjustment
FUNDING BENEFIT ADJUSTMENT (“FBA”)
• Trade with non-CSA counterparty and Hedge with CSA counterparty
• Assume trade between End User and Bank has negative mark-to-market from perspective of Bank, therefore Positive MtM on hedge
• The Bank gets Collateral posted on the hedge but doesn’t have to post any to the End User
• The Bank is generating funding to the Collateral they have received
• FBA <=> DVA
Funding Value Adjustment = Funding Cost Adjustment + Funding Benefit Adjustment
End User Bank Hedge
Post CollateralNo Collateral
OIS
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The xVAs
No CSA "Old" CSA CCP
CVA & DVA
FVA
KVA
ColVA
MVA
© 2016 Thomson Reuters 61
Thank you!