The xVA Challenge

Counterparty Risk, Funding, Collateral, Capital and Initial Margin

Jon Gregory

• Publisher: Wiley
• Year: 2020
• ISBN:
  9781119509004
• Edition: 4
• Topic: Business
• Subtopic: Finance
• Index: Business

A thoroughly updated and expanded edition of the xVA challenge

The period since the global financial crisis has seen a major re-appraisal of derivatives valuation, generally expressed in the form of valuation adjustments ('xVAs'). The quantification of xVA is now seen as fundamental to derivatives pricing and valuation. The xVA topic has been complicated and further broadened by accounting standards and regulation. All users of derivatives need to have a good understanding of the implications of xVA. The pricing and valuation of the different xVA terms has become a much studied topic and many aspects are in constant debate both in industry and academia.

• Discussing counterparty credit risk in detail, including the many risk mitigants, and how this leads to the different xVA terms
• Explains why banks have undertaken a dramatic reappraisal of the assumptions they make when pricing, valuing and managing derivatives
• Covers what the industry generally means by xVA and how it is used by banks, financial institutions and end-users of derivatives
• Explains all of the underlying regulatory capital (e.g. SA-CCR, SA-CVA) and liquidity requirements (NSFR and LCR) and their impact on xVA
• Underscores why banks have realised the significant impact that funding costs, collateral effects and capital charges have on valuation
• Explains how the evolution of accounting standards to cover CVA, DVA, FVA and potentially other valuation adjustments
• Explains all of the valuation adjustments – CVA, DVA, FVA, ColVA, MVA and KVA – in detail and how they fit together
• Covers quantification of xVA terms by discussing modelling and implementation aspects.

Taking into account the nature of the underlying market dynamics and new regulatory environment, this book brings readers up to speed on the latest developments on the topic.

Section 1
Basics

1
Introduction

In 2007, a global financial crisis (GFC) started which eventually became more severe and long-lasting than could have ever been anticipated. Along the way, there were major casualties such as the bankruptcy of the investment bank Lehman Brothers. Governments around the world had to bailout other financial institutions such as American International Group (AIG) in the US and the Royal Bank of Scotland in the UK.

The GFC caused a major focus on counterparty credit risk (CCR) which is the credit risk in relation to derivative products. A derivative trade is a contractual relationship that may be in force from a few days to several decades. During the lifetime of the contract, the two counterparties have claims against each other such as in the form of cash flows that evolve as a function of underlying assets and market conditions. Derivatives transactions create CCR due to the risk of insolvency of one party. This CCR in turn creates systemic risk due to derivatives trading volume being dominated by a relatively small number of large derivatives counterparties (‘dealers’) that are then key nodes of the financial system.

Post-GFC, participants in the derivatives market became more aware of CCR and its quantification via credit value adjustment (CVA). They also started to create more value adjustments, or xVAs, in order to quantify other costs such as funding, collateral, and capital. Derivatives pricing used to be focused on so-called ‘exotics’ with the majority of simple or vanilla derivatives thought to be relatively straightforward to deal with. However, the birth of xVA has changed this and even the most simple derivatives may have complex pricing and valuation issues arising from xVA.

Regulation has also enhanced the need to consider xVA (or XVA). Increasing capital requirements, constraints on funding, liquidity, and leverage together with a clearing mandate and bilateral margin requirements all make derivatives trading more expensive and complex. However, derivatives are still fundamentally important: for example, without them end users would have to use less effective hedges, which would create income statement volatility. The International Swaps and Derivatives Association (ISDA 2014b) reports that 85% of end users said that derivatives were very important or important to their risk management strategy and 79% said they planned to increase or maintain their use of over-the-counter (OTC) derivatives.

This book aims to fully explain xVA and the associated landscape of derivatives trading. Chapters 2 to 5 will discuss the basics of derivatives, regulation, CCR, and introduce the concept of xVA. Chapters 6 to 10 will discuss risk mitigation methods such as netting, margining, and central clearing. Chapters 11 to 15 will cover the building blocks of xVA such as exposure, credit spreads, funding, and capital costs. Finally, Chapters 16 to 20 will define the xVAs in sequence whilst also discussing their relationships to one another. Chapter 21 will discuss the ‘xVA desk’ and management of xVA.

The online Appendices and Spreadsheets provide more detail on various xVA calculations. This book is a relatively non-mathematical treatment of xVA. For a more mathematically-rigorous text for quantitative researchers, Andrew Green's book (Green 2015) is strongly recommended.

2
Derivatives

2.1 INTRODUCTION

Derivatives transactions represent contractual agreements either to make payments or to buy or sell an underlying security at a time or times in the future. The times may range from a few weeks or months (for example, futures contracts) to many years (for example, long-dated swaps). The value of a derivative will change with the level of one or more underlying assets or indices and possibly decisions made by the parties to the contract. In many cases, the initial value of a traded derivative will be contractually configured to be zero for both parties at inception.

Derivatives are not a particularly new financial innovation; for example, in medieval times, forward contracts were popular in Europe. However, derivatives products and markets have become particularly large and complex in the last three decades. One of the advantages of derivatives is that they can provide very efficient hedging tools. For example, consider the following risks that an institution, such as a corporate, may experience:

• Interest rate risk. They need to manage liabilities such as transforming floating- into fixed-rate debt via an interest rate swap.
• Foreign exchange (FX) risk. Due to being paid in various currencies, there is a need to hedge cash inflow in these currencies, for example, using FX forwards.
• Commodity risk. The need to lock in commodity prices either due to consumption (e.g. airline fuel costs) or production (e.g. a mining company) via commodity futures or swaps.

In many ways, derivatives are no different from the underlying cash instruments. They simply allow one to take a very similar position in a synthetic way. For example, an airline wanting to reduce its exposure to a potential rise in oil price can buy oil futures, which are cash-settled and therefore represent a very simple way to go ‘long oil’ (with no storage or transport costs). An institution wanting to reduce its exposure to a certain asset can do so via a derivative contract (such as a total return swap), which means it does not have to sell the asset directly in the market.

There are many different users of derivatives such as sovereigns, central banks, regional/local authorities, hedge funds, asset managers, pension funds, insurance companies, and non-financial corporations. All use derivatives as part of their investment strategy or to hedge the risks they face from their business activities. Due to the particular hedging needs of institutions and related issues, such as accounting, many derivatives are relatively bespoke. For example, a corporation wanting to hedge the interest rate risk in a floating-rate loan will want an interest rate swap precisely matching the terms of the loan (e.g. maturity, payment frequency, and reference rate).

Financial institutions, mainly banks, provide derivative contracts to their end user clients and hedge their risks with one another. Whilst many financial institutions trade derivatives, many markets are dominated by a relatively small number of large counterparties (often known as ‘dealers’). Such dealers represent key nodes of the financial system. For example, there are currently around 35 globally-systemically-important banks (G-SIBs), which is a term loosely synonymous with ‘too big to fail’. G-SIB banks are subject to stricter rules, such as higher minimum capital requirements.

During the lifetime of a derivatives contract, the two counterparties have claims against each other, such as in the form of cash flows that evolve as a function of underlying assets and market conditions. Derivatives transactions create counterparty credit risk (counterparty risk) due to the risk of insolvency of one party. Counterparty risk refers to the possibility that a counterparty may not meet its contractual requirements under the contract when they become due.

Counterparty risk is managed over time through clearing; this can be performed bilaterally, where each counterparty manages the risk of the other, or centrally through a central counterparty (CCP). As the ...

Table of contents

• Cover
• Table of Contents
• List of Spreadsheets
• List of Appendices
• Acknowledgements
• About the Author
• Section 1: Basics
• Section 2: Risk Mitigation
• Section 3: Building Blocks
• Section 4: The xVAs
• Glossary
• References
• Index
• End User License Agreement