Credit Valuation Adjustment

Implementation of CVA

PRMIA Credit Valuation Adjustment (CVA) CONGRESS

IMPLEMENTATION UND PRAXIS

Wolfgang Putschögl

Köln, 20th July 2011

 CVA in a nutshell

 Usually pricing of derivatives does not take

the possibility of default into account
Exposure E
Et
 E.g. Value of Option V(t,T)
(1-R)e-rt Et

 Price should be adjusted for default risk Time t

ti ti+1

 VRisky(t,T) = V(t,T) – CVA (t,T) …+x + x + x + … = CVA

 CVA is correction for credit-risk free

calculations!

Probability of Default

expected value short rate exposure at time t

Time t
ti ti+1

recovery rate of counterpart probability of default of the counterpart

2 time of default
 CVA and CCR Model
Macro Process Overview

Market data is received and a set of scenarios is produced with reference to each relevant risk
Scenario factor/driver
Generation The output is a set of evolutions of risk factor scenarios (interest rates, volatilities, spreads …)

Value computed of every trade comprised in the defined perimeter at any time step for the full set
of scenarios
Position
Output is a cube of mark-to-futures
Revaluation

Aggregating the mark-to-futures computed along any scenario according to netting and margining
Output agreements. Computation of relevant risk figures/Metrics (Exposure measures, CVA, …)
Aggregation

TARGET SERVICES

REGULATORY CCR CVA

Exposure Measures Effective EPE/ CVA desk
Credit Limit Mgt
Stressed EPE (*) services
Collateral CVA Transfer
CVA VaR (*)
control Pricing
• Expected Exposure CCR P&L allocation
• EPE RWAs (*)
Monitoring and control
• Effective EPE Concentration
Back-testing CVA Accounting
• Stressed EPE Risk reporting
• Marginal EPE Stress
Testing (*) Introduced or enriched by Basel III
• PFE

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 CVA and CCR Model
Operating Model – Critical activities

1 CAPITAL MARKET (CVA) Critical Cross Actitivities RISK MANAGEMENT (CCR)

Scenario 4 Market Data Scenario

Market Data Market Data
Scenario Generation produc. and maint. Generation
Generation Model define and 5 Scenario 7 Exposure Model define and
Stress tests
2 development Generation Measurement development
Exposure Intraday limit 6 8 c/p Mgt, review Exposures
Intraday checks c/p review/mgt
measurement check and aggr. measurement
Position Intraday CVA 9 Regulatory
Revaluation CVA Hedging Risk Reporting Risk Reporting
Pricing reporting

c/p modelling, Wrong way risk

3 Greeks Monitoring Backtesting
assessment
mapping
CVA Desk risk
Output P&L measurement Concentration risk
limits monitoring
Aggregation

DATA MANAGEMENT (INPUT/OUTPUT; REPOSITORY; AUDIT CHECKS; …)

1 4
Risk factor scenario are used to get possible
evolution of exposures. The same framework
can be used for both regulatory purposes
(EoD) and intraday trading needs.
2 5
Based on the risk factor scenarios, a full re-
pricing of the portfolio is needed at each future
time grid point until the last expiry date.
3 Once the value of each trade in the portfolio is 6 9
known until maturity, mark to futures must be
aggregated according to the available legal
agreements (netting/collateral) in order to get
the exposures
7
• Market data acquisition and validation
• Unobservable market data computations
(correlations, illiquid names PDs)
• Historical series storage
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• Financial models definition for risk factor evolution
(scenario generation)
• Model calibration with historical (Limit/Regulatory)
and risk neutral parameters (for CVA)
• Pre-deal: computation of the CVA charge to clients
(incremental CVA)
• Pre-deal: Credit Limit check based on PFE
• Intraday: ‘On demand’ monitoring of CVA and PFE
• Definition of Financial pricing libraries for
intraday and batch portfolio revaluation
• Intraday to allow CVA desk risk limits control
• Batch to measure risk exposures and RWAs
• Defines netting nodes and aggregation rules
• Management of counterparty specific data
(Counterparty Group),
• Regulatory reporting
• Credit limits reports (PFE)
• Stress testing results and Wrong way risk
• Concentration risk (per issuer, country, …)

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 CVA and CCR Functional Model

Trading

Fixed Income FX and Money Repos and

Equities Market Data
(Rates, Credit) Market Lending

Pre-deal limit check, trade approval, CVA Charge

Market Data

Trade Data, EOD and Intra Day

Scenario Generator
Pre-Deal
(support for risk neutral (CVA) and historic (Limit) scenarios)
Risk and Valuation

Limit and CVA Incremental Credit

Check Exposure, CVA
Current
Market Data
Exceptions
Limits
P&L Vectors,
Revaluation Engines
Limit/CVA Sensitivities Trade and Positions
Manager,
Aggregation Engine
Exception
Manager Exposure
Netting
Product Eligibility, Limits

CVA, CVA Credit Hierarchies

Sensitivities, Counterparty Data, PDs Agreements
CVA Charge
RWA Collateral
Balances
Results
Data

Counterparty Legal, Netting Trade and

Data (Exposure,
Data Agreements Position Data
CVA,RWA)

Adjustments
Controls

Internal and
Client Stress Test, Collateral Controls and
Regulatory
Onboarding Back Testing Management Adjustments
Reporting

Legal Agreements CSAs

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 CVA Trading Desk - Transaction Lifecycle and Position Valuation

Product Control

Trading Desks Position Valuation & PnL

Client Risk Free MTM

Transaction Price / PnL Net Trading
Desk Position

Hedging
Hedging Valuation &
PnL
Financial Accounting
CVA Cash Trading Desk
Payment PnL
Reconciliation
Income Statement

CVA Trading Change in CVA

Position Valuation & PnL Trading Desk
Desk Valuation &
PnL
CVA Desk PnL
CVA Cash
CVA Charge Change in CVA
Balance
Cash Balance Valuation &
Reconciliation
CVA Desk PnL Balance Sheet

CVA Valuation
CVA Valuation
& PnL Fair Value
OTC Derivative
Adjustment of
Net CVA Desk Position MTM
CVA Hedging CVA
CVA Hedging Cash & Hedge
Valuation & Position
Book
PnL

• Total Net CVA per

Counterparty ISDA

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 Implementing CVA - practical considerations

 Active approach vs. Passive approach

Active approach Passive approach

(profit center ) (utility function)

•Pricing new trades Mandate of CVA desk?

•Pricing new trades
•Active hedging
•Monitoring of CVA
•What hedging strategies?
•Accounting CVA

 IT Architecture (Build vs. buy)

 Data challenges
 Define relevant data necessary to calculate and aggregate CVA
 Business processes
 Forthcoming regulatory requirements

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 Implementing CVA - practical considerations…cont‘d

Methodology

 Unilateral vs. bilateral

 Risk neutral scenarios for exposure calculation
 blend of market implied and historic market data
 Modelling of probabilities of default
 historic vs. risk neutral
 choice of mapping approach
 Client segmentation
 observability of clients (liquid vs. illiquid c/p)
 Wrong way risk design and implementation
 Gap risk (for CSAs)

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 Implementing CVA - practical considerations…cont‘d
Credit Mapping - Example

CDS Region Client Type Index Name Sector Rating

Financials, Govt, Basic

Materials, Consumer
Itraxx EUR HiVOL
Goods, Consumer
Invest. Itraxx EUR Non-Fin Services, Health Care,
Grade Itraxx EUR SnrFin Industrials, Oil & Gas,
Technology, Telecoms,
Utilities
EUR AAA
AA
CDS A
Speculative Itraxx EUR Xover BBB
Index
Grade Itraxx EUR SnrFin BB
Proxy
B
CCC
CEE Itraxx SovX CEE
Western Eur Sovereigns Itraxx SovX WE
Asia Pacific Itraxx SovX AP
CDX IG
US
CDX HY
Single
name
CDS

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 CVA Trading
Market risk limits

 To manage CVA risks the CVA Trading Desk needs to be able to hedge
 Credit risk: trade any products (credit products, derivatives,…),
 EPE (Underlying risks on the derivatives): trade instruments relevant for hedging
e.g. interest rate swaps, fx forwards, volatility products.

 CVA VaR – economic CVA VaR vs Basel III CVA VaR

 CVA VaR managed by CVA Trading Desk
 Basel III CVA VaR only for CS01 (for computational reasons), still reliable
sensitivities helpful to support what-if analysis for hedging
 Discrepancy between hedging economic CVA VaR (including exposure sensitivities)
and Basel III CVA VaR (only CS01)

 No VaR limit for hedging trades on CVA desk

 Granular Market Risk Limits

 Risk metrics/sensitivities have to be produced without excessive noise and proven
P&L attributive ability

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