Managing Counterparty Credit Risk through CVA. Karin Bergeron Director, CVA Trading
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1 Managing Counterparty Credit Risk through CVA Karin Bergeron Director, CVA Trading
2 Agenda 1. Background 2. Motivation for CVA desk 3. Organization/Mandate of CVA desk 4. Pre-trade/Deal-time pricing of CVA 5. Managing CCR/CVA P&L 6. Conclusions 7. Questions 2011 Algorithmics Software LLC. Confidential 2
3 Background: Counterparty Credit Risk Industry History: 2011 Algorithmics Software LLC. Confidential 3
4 Background: CVA Calculation Credit Valuation Adjustment (CVA) is the difference between the riskfree value of a portfolio and the true value of that portfolio, accounting for the possible default of a counterparty. Bilateral Calculation: Bank s expected loss to counterparty counterparty s expected loss to bank: Price at which, including credit effects, both parties in a transaction should agree to trade Arm s length intermediation value for risk-free third party Portfolio Calculation: calculated at the counterparty level then summed across counterparties Applies to all counterparties 2011 Algorithmics Software LLC. Confidential 4
5 Agenda 1. Background 2. Motivation for CVA desk 3. Organization of CVA desk 4. Pre-trade/Deal-time pricing of CVA 5. Managing CCR/CVA P&L 6. Conclusions 7. Questions 2011 Algorithmics Software LLC. Confidential 5
6 Motivation for CVA Desk Bank s Major Objectives for CVA: Introduce a buffer of reserves to insure overall losses arising from counterparty risk Provide a fair value for derivatives transactions Primary Responsibilities of CVA Desk: Pre-trade pricing of CVA Managing P&L of the CVA Managing JTD Risk in the bank s portfolio 2011 Algorithmics Software LLC. Confidential 6
7 Agenda 1. Background 2. Motivation for CVA desk 3. Organization/Mandate of CVA desk 4. Pre-trade/Deal-time pricing of CVA 5. Managing CCR/CVA P&L 6. Conclusions 7. Questions 2011 Algorithmics Software LLC. Confidential 7
8 Organization/Mandate of CVA desk For optimal efficiency banks should have: One centralized CVA desk Netted co-simulated calculation Centralized management of CVA Centralized expertise Unified stream of development for technology Blended Utility Function/Profit Centre Lack of control on trade inflow CVA Desk is the only option to trade with Transfer Pricing Responsible for and manage P&L 2011 Algorithmics Software LLC. Confidential 8
9 Organization/Mandate of CVA desk Technology Considerations: Separate counterparty credit risk system Connectivity from CCR system to all product systems Connectivity to collateral system Market data Computational intensity Valuation CVA calculation 2011 Algorithmics Software LLC. Confidential 9
10 Agenda 1. Background 2. Motivation for CVA desk 3. Organization/Mandate of CVA desk 4. Pre-trade/Deal-time pricing of CVA 5. Managing CCR/CVA P&L 6. Conclusions 7. Questions 2011 Algorithmics Software LLC. Confidential 10
11 Pre-trade/Deal-time pricing of CVA Why do we need this: Know the actual fair value of new trade/unwind/option exercise Determine transfer pricing with CVA desk Also can be used to: Identify bad trades Identify most credit-risk efficient trading counterparties Identify profitable novation opportunities 2011 Algorithmics Software LLC. Confidential 11
12 Pre-trade/Deal-time pricing of CVA How should this be done (in theory): Marginal impact on entire portfolio including same day trades CVA/DVA netted reflective of actual P&L impact to bank Current pricing market data rates, credit spreads/proxy spreads, fx, etc Volatility and correlations between market risk factors Correlations b/w exposure and creditworthiness (right way/wrong way risk) CVA for each trade paid to the CVA desk 2011 Algorithmics Software LLC. Confidential 12
13 Pre-trade/Deal-time pricing of CVA F/O Product System New trade info Update portfolio Inception pricing CVA overrides CVA Engine Book trade Nonstandard queue CVA override What-if trade What-if CVA Diagnostic GUI View/adjust model inputs What-if trade Marketer CVA CVA CVA desk ALGORITHMICS, Ai Logo, ALGORITHMICS & Ai Logo, ALGO, MARK TO FUTURE, RISKWATCH, KNOW YOUR RISK, ALGO RISK, ALGO MARKET, ALGO CREDIT, ALGO COLLATERAL, ALGO FIRST, ALGO ONE, ALGO FOUNDATION, ALGO FINANCIAL MODELER, ALGO OPVAR and TH!NK Logo are trademarks of Algorithmics Trademarks LLC Algorithmics Software LLC. Confidential 13
14 Pre-trade/Deal-time pricing of CVA Technology Considerations: Tool deployed to marketing desk with as much automation/information as possible Exposure profiles, PFE, CVA/DVA, credit spreads Speed of calculation can be critical how to calculate efficiently Regenerate scenarios and revalue vs. model approximations vs. use pre-computed portfolio exposures Who wears that risk? Manual adjustments P&L decomposition tool to reconcile P&L due to new trades with cash inflow Tool for creating proxy CDS curves where none available 2011 Algorithmics Software LLC. Confidential 14
15 Pre-trade/Deal-time pricing of CVA 2011 Algorithmics Software LLC. Confidential 15
16 Agenda 1. Background 2. Motivation for CVA desk 3. Organization/Mandate of CVA desk 4. Pre-trade/Deal-time pricing of CVA 5. Managing CCR/CVA P&L 6. Conclusions 7. Questions 2011 Algorithmics Software LLC. Confidential 16
17 Managing CCR/CVA P&L Ways to manage CCR (in theory): JTD hedging Not available for all names, or even a majority of names Can only have JTD limits on some names not consistent treatment Hedge sensitivity to market moves, take only defined risks where desirable Many market factors to hedge rates, vol, fx, credit spreads, correlations, commodity prices, equity prices. Assess biggest risks in the book; actively manage those taking positions where desirable. Continually reassess your actual positions. Hedge DVA? Macro hedge? 2011 Algorithmics Software LLC. Confidential 17
18 Managing CCR/CVA P&L CVA Workflows: Put on desired hedges, monitor position and P&L Use CDS mainly and CCDS to hedge credit risk Use base instruments: bonds, swaps, forex etc to hedge exposure risk PL Predict vs Explain Understand any differences in estimated vs actual P&L Use P&L explain for evaluation of CVA desk performance Any unmanaged factors can be separated from managed factors (ie DVA) and P&L taken at management level rather than desk level 2011 Algorithmics Software LLC. Confidential 18
19 Managing CCR/CVA P&L Technology Considerations: Valuation CVA calculation CVA Sensitivities 2011 Algorithmics Software LLC. Confidential 19
20 Managing CCR/CVA P&L Technology Considerations: Sensitivity calculations Computational intensity possibly in the thousands of scenarios required Tool required for investigation Trading tool aggregating risk in CVA with hedge PL Decomposition Decompose P&L into underlying risk factors by moving one at a time Includes market factors, changes to netting/collateral, new trade P&L Tool to view historically 2011 Algorithmics Software LLC. Confidential 20
21 Agenda 1. Background 2. Motivation for CVA desk 3. Organization/Mandate of CVA desk 4. Pre-trade/Deal-time pricing of CVA 5. Managing CCR/CVA P&L 6. Conclusions 7. Questions 2011 Algorithmics Software LLC. Confidential 21
22 Conclusions Setting up an effective CVA desk requires appropriate: Organization Expertise Technology 2011 Algorithmics Software LLC. Confidential 22
23 Questions? 2011 Algorithmics Software LLC. Confidential 23
24 Thank you for your time For further information, contact: Karin Bergeron Director, CVA Trading Scotia Capital +1 (416) ALGORITHMICS, Ai Logo, ALGORITHMICS & Ai Logo, ALGO, MARK TO FUTURE, RISKWATCH, KNOW YOUR RISK, ALGO RISK, ALGO MARKET, ALGO CREDIT, ALGO COLLATERAL, ALGO FIRST, ALGO ONE, ALGO FOUNDATION, ALGO FINANCIAL MODELER, ALGO OPVAR and TH!NK Logo are trademarks of Algorithmics Trademarks LLC Algorithmics Software LLC. Confidential 24
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