The xva Challenge. Counterparty Credit Risk, Funding, Collateral and Capital. Third Edition. Jon Gregory
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1 The xva Challenge Counterparty Credit Risk, Funding, Collateral and Capital Third Edition Jon Gregory WILEY
2 Contents List of Spreadsheets List of Appendices Acknowledgements About the Author xix xxi xxiii xxv 1 Introduction 1 2 The Global Financial Crisis Pre-crisis The crisis Regulatory reform Backlash and criticisms A new world 10 3 The OTC Derivatives Market The derivatives market Derivatives Exchange traded and OTC derivatives Market size Market participants Credit derivatives The dangers of derivatives The Lehman experience Derivative risks Market risk Credit risk Operational and legal risk Liquidity risk Integration of risk types 20
3 viii Contents Counterparty risk Risk management of derivatives Value-at-risk Models Correlation and dependency 23 4 Counterparty Risk Background Counterparty risk versus lending risk Settlement and pre-settlement risk Mitigating counterparty risk Exposure and product type Setups Components Mark-to-market and replacement cost Credit exposure Default probability, credit migration and credit spreads Recovery and loss given default Control and quantification Credit limits Credit value adjustment CVA and credit limits What does CVA represent? Hedging counterparty risk TheCVAdesk Beyond CVA Overview Economic costs of an OTC derivative xva terms Summary 46 5 Wetting, Close-out and Related Aspects Introduction Overview The need for netting and close-out Payment and close-out netting Default, netting and close-out The ISDA Master Agreement Events of default Payment netting Close-out netting Product coverage and set-off rights Close-out amount The impact of netting Multilateral netting and trade compression Overview Multilateral netting 56
4 Contents ix Bilateral compression services The need for standardisation Examples Termination features and resets Walkaway features Termination events Reset agreements Summary 65 6 Collateral Introduction Rationale for collateral Analogy with mortgages Variation margin and initial margin Collateral terms The credit support annex (CSA) Types of CSA Threshold Initial margin Minimum transfer amount and rounding Haircuts Linkage to credit quality Credit support amount Impact of collateral on exposure Mechanics of collateral Collateral call frequency Valuation agents, disputes and reconciliations Title transfer and security interest Coupons, dividends and remuneration Collateral and funding Overview Substitution Rehypothecation Segregation Variation and initial margin rehypothecation and segregation Standard CSA Collateral usage Extent of collateralisation Coverage of collateralisation Collateral type The risks of collateral Collateral impact outside OTC derivatives markets Market risk and the margin period of risk Operational risk Legal risk Liquidity risk Funding liquidity risk 98
5 x Contents 6.7 Regulatory collateral requirements Background Covered entities General requirements Haircuts ' Segregation and rehypothecation Initial margin calculations Standardised initial margin method (SIMM) Converting counterparty risk into funding liquidity risk Summary Credit Exposure and Funding Credit exposure Definition Bilateral exposure The close-out amount III Exposure as a short option position Future exposure Comparison to value-at-risk Metrics for exposure Expected future value Potential future exposure Expected exposure EE and PFE for a normal distribution Maximum PFE Expected positive exposure Negative exposure Effective expected positive exposure (EEPE) Factors driving exposure Loans and bonds Future uncertainty Periodic cashflows Combination of profiles Optionality Credit derivatives The impact of netting and collateral on exposure The impact of netting on future exposure Netting and the impact of correlation Netting and relative MTM Impact of collateral on exposure Funding, rehypothecation and segregation Funding costs and benefits Differences between funding and credit exposure Impact of segregation and rehypothecation Impact of collateral on credit and funding exposure Examples Summary 141
6 Contents xi 8 Capital Requirements and Regulation Background to credit risk capital Standardised approach Internal ratings-based approach (IRB) Double default Exposure at default (EAD) Incurred CVA Current exposure method (CEM) Add-ons Netting and collateral treatment The internal model method (IMM) Background The alpha factor and EEPE Standardised approach for counterparty credit risk (SA-CCR) Background Basic approach Netting Collateral Overcollateralisation and negative MTM Comparison of EAD methods Impact of maturity Collateral Negative MTM Initial margin and threshold Netting Basel III Overview Stressed EPE Increased margin period of risk Backtesting Wrong-way risk Stress testing CVA capital charge Rationale Standardised formula Advanced approach Example Criticisms US Implementation The European exemptions Other important regulatory requirements Fundamental review of the trading book Leverage ratio Floors Liquidity coverage ratio and net stable funding ratio Prudent value Summary 183
7 xii Contents 9 Counterparty Risk Intermediation 9.1 Introduction ' SPVs, DPCs, CDPCs and monolines Default remoteness and "too big to fa.il" Special purpose vehicles Derivative product companies Monolines and CDPCs Central counterparties The Clearing mandate OTC Clearing The CCP landscape CCP risk management Comparing bilateral and central Clearing Advantages and disadvantages of CCPs CCP capital charges What central Clearing means for xva Summary Quantifying Credit Exposure Introduction Methods for quantifying credit exposure Parametric approaches Semi-analytical methods Monte Carlo Simulation Monte Carlo methodology Simulation model Scenario generation Revaluation Aggregation Post-processing Extraction Real-world or risk-neutral Two fundamentally different approaches Drift Volatility Correlation Market practice Model choice Risk-neutral or real-world? Level of complexity General comments Correlations Examples -> Data set -> Exposures profiles -> Allocating exposure Simple two-transaction, single-period example 235
8 Contents xiii Incremental exposure Marginal exposure Summary Exposure and the Impact of Collateral Overview General impact of collateral Modelling approach Margin period of risk Setup Amortisation Conditionality Disputes MPR discretisation and cashflows MPR modelling Numerical examples Collateral assumptions Margin period of risk impact Simple approximations Discretisation and cashflows Impact of threshold Do two-way CSAs always reduce exposure? Non-cash collateral Collateral and funding liquidity risk Initial margin Impact of initial margin on exposure Dynamic initial margins Segregation and funding exposure Summary Default Probabilities, Credit Spreads and Funding Costs Overview Default probability Real-world and risk-neutral The move to risk-neutral Defining risk-neutral default probabilities Term structure Loss given default Credit curve mapping Overview The CDS market Loss given default General approach Generic curve construction General approach Third party curves Mapping approach 282
9 xiv Contents Cross-sectional approach Hedging Funding curves and capital costs Background Funding costs Defining a funding curve Cost of capital Summary Discounting and Collateral Overview Discounting Introduction OIS rates The risk-free rate Perfect collateralisation and discounting OIS discounting OIS methodology Beyond perfect collateralisation The push towards perfect collateralisation The xva terms Collateral valuation adjustments Overview Collateral rate adjustments Collateral optionality Non-cash collateral The end of Co!VA Summary Credit and Debt Value Adjustments Overview Credit value adjustment Why CVA is not straightforward History of CVA CVA formula CVA example CVA as a spread Exposure and discounting Risk-neutrality CVA semi-analytical methods Impact of credit assumptions Credit spread impact Recovery impact CVA allocation and pricing 3 ] Netting and incremental CVA Incremental CVA example Marginal CVA 319
10 Contents xv CVA as a spread Numerical issues CVA with collateral Impact of margin period of risk Thresholds and initial margins Debt value adjustment Overview Accounting Standards and DVA DVA and pricing Bilateral CVA formula Close-out and default correlation Example DVA and own-debt DVA in derivatives Summary Funding Value Adjustment Funding and derivatives Why there are funding costs and benefits The nature of funding costs and benefits Relationship to CVA and DVA FVA in financial statements Funding value adjustment Intuitive definition Discountingapproach More complex cases Contingent FVA Allocation of FVA The practical use of FVA Link to DVA CVA/DVA/FVA framework Is FVA really Symmetrie? Defining the funding rate The Hull and White and accounting arguments Resolving the FVA debate Remaining issues Example Summary LCH/CME Basis and Capital Value Adjustments Overview Margin value adjustment Rationale IM profiles MVA formula Example Capital value adjustment 366
11 xvi Contents Rationale Capital profiles Formula Term structure behaviour Behavioural aspects and regulatory change Example KVA and MVA Overlaps and hedging KVA reporting Summary Wrong-way Risk Overview Overview of wrong-way risk Simple example Classic example and empirical evidence General and specific WWR WWR challenges Quantification of wrong-way risk Wrong-way risk and CVA Simple example Wrong-way collateral Wrong-way risk modelling approaches Hazard rate approaches Structural approaches Parametric approach Jump approaches Credit derivatives Wrong-way risk and collateral Central Clearing and wrong-way risk Summary xva Management Introduction The role of an xva desk Motivation Role Profit centre or Utility? Operation and rollout Hedging xva Motivation xva as an exotic option Misalignment Market risk Credit, funding and capital hedging Cross-gamma P&L explain 407
12 Contents xvii Capital relief from hedges Market practica and hedging xva systems Overview Optimisations Shared or separate implementations Internal and vendor systems IMM approval Summary xva Optimisation Overview Market practice General approach to xva Totem Examples xva assumptions Uncollateralised Off-market Partially collateralised One-way collateralised Collateralised Overcollateralised (initial margin) and backloading Costs and the balance of xva terms Spectrum of transaction Optimising xva Impact of credit quality and maturity Summary xva optimisation Intermediation Restrikes Uncollateralised to collateralised Backloading to a CCP Summary The Future 443 Glossary 445 References 447 Index 457
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