Citi CVA Example
Citi CVA Example
Citi CVA Example
Counterparty credit risk pricing, assessment, and dynamic hedging Citigroup Global Markets, James Lee
March 2010
Table of Contents
1. Introduction 2. CVA Methodology 3. Dynamic Hedging 4. Residual Risks
1. Introduction
Introduction
A critical element of the derivative business going forward will be to trade with on an uncollateralised or partially collateralized basis with counterparties. Previously, valuation of counterparty credit risk has largely been ignored due to relatively smaller size of the derivative exposures and the high credit rating of the counterparties which were generally AAA or AA rated financial institutions. As the size of the derivative exposure increases and the credit quality of the counterparties falls, the valuation of counterparty credit risk can no longer be assumed to be negligible and must be appropriately priced and charged for. Credit Valuation Adjustment or CVA is the process through which counterparty credit is valued, priced and hedged. We can no longer assume that derivatives exposures are credit risk remote. CVA is the credit reserve process and is analogous to MTM of bonds, loan loss reserves for loan or accounts receivables. CVA management involve managing of counterparty credit risk on the Asset side as well as Liability side risk and funding risk. This is analogous to Asset Liability Management for derivatives. CVA is important to create correct incentives for trading and avoid adverse selection. Risky counterparties migrate to banks without CVA. Negative funding trade migrates to non-CVA banks.
Introduction
2. CVA Methodology
Introduction
What is market CVA?
Market CVA is the credit reserve adjustment made to derivatives transactions to account for counterparty risk Market CVA is bilateral at the financial reporting level. Bilateral CVA consists of Asset CVA this represents the expected cost of Citis counterparty exposures (loans) Liability CVA this is the expected credit costs incurred by the counterparty (deposits) Bilateral market CVA can be thought of as the net market value of an American option by both sides to default on the derivative
How is it calculated?
The methodology to calculate both Asset CVA and Liability CVA is similar. In the formula below, we do not differentiate between asset/liability CVA. CVA is the expected value of credit losses over the lifetime of the trade. i.e. CVA at each time bucket = PV (EAD * (1 Recovery Rate) * Probability of Default) where EAD = Exposure at Default at each time bucket. This is predicted by EPE/ENE profiles EPE/ENE = Expected Positive and Negative Exposures of the portfolio. These are generated using the market implied volatilities of market risk factors Recovery Rate = 50% (Assumed) Probability of Default = Derived through market CDS spreads Bilateral CVA is the sum of the Asset and Liability CVA
Client
After CVA
CVA Option Bank
The Swap Trader will pay a premium to the CVA trader to buy a CVA option The CVA option will protect the Swap Trader against any loss due to the default of the Client on the swap The CVA trader will hedge the Credit risk in the CDS market
CVA Methodology
Buy CDS
Client
Swap Trader
CVA Trader
CDS Market
Years
Calculate the expected mark to market (MTM) value of the swap over time by calculating the Asset Profile - The expected MTM value for those situations when the Bank is owed money
CVA Methodology
MTM (Bank)
Exposure at Default for the bank if counterparty defaults at time t * (1 Recovery Rate)
Discount Factors, CPs CDS
0 Today
Time
Exposure at Default for the counterparty if bank defaults at time t * (1 Recovery Rate)
Bilateral CVA is the sum of asset and liability CVA at each tenor bucket over the life of the trade
Expected Negative Exposure
MTM (Bank)
Exposure at Default for the bank if counterparty defaults at time t * (1 Recovery Rate)
10 MM
Discount Factors, CPs CDS
Today
Discount Factors, Citis CDS
Time
Exposure at Default for the counterparty if the bank defaults at time t * (1 Recovery Rate)
MTM (Bank)
Exposure at Default for the bank if counterparty defaults at time t * 0.5 (1 Recovery Rate)
Discount Factors, CPs CDS
Today
Discount Factors, Citis CDS
Time
-10 MM
Exposure at Default for the counterparty if the bank defaults at time t * 0.5 (1 Recovery Rate)
3. Dynamic Hedging
CVA Methodology
Dynamic Hedging
Concepts
Dynamic Hedging Hedging the value of expected loss requires hedging its sensitivity to market factors and credit quality Because these factors move, and the CVAs sensitivity to them changes, hedging needs to be rebalanced Friction Each individual market factor is hedged, but correlated moves will cause net losses Also, transaction costs per se, need to be accounted for Time Decay As time passes, the life of the deal shortens and, all else constant, the expected loss falls Thus, like an option premium, all else constant, a CVAs value will fall over time
T=0
T=0
No net gain or loss FX Moves +100 pips Expected Loss increases 21k; offset by gain in FX Hedge
After the shift, sensitivities are recalculated and hedges are rebalanced
FX + 100 1.3700 Sensitivity to FX Moves CVA FX01 424 21 Hedge 2100 CR + 10 103 Sensitivity to Credit Curve Moves CVA CR01 Hedge 443 40 8,000
T=0
T=0
No net gain or loss Credit Curve Moves +10 bps Expected Loss increases 40k; offset by gain in Credit Hedge
After the shift, sensitivities are recalculated and hedges are rebalanced
FX + 100 1.3700 Sensitivity to FX Moves CVA FX01 466 23 Hedge 2300 CR + 10 113 Sensitivity to Credit Curve Moves CVA CR01 Hedge 483 40 8,000
Now assume that FX and the Credit Curve move by the amount hedged for (+100pips/+10bps) But assume that they both move together, simultaneously
FX and Credit Curve Move Simultaneously FX 1.3700 5y Credit 113 CVA 508
CVA (65) PnL FX Hedge Credit Hedge 23 40 Net PnL (2)
T=0
The increase in Expected Loss is more than the sum of the individual hedge PnL
Exposure
Exposure
Short Tenor
Long Tenor
The flipside to this: after inception, CVA value is subject to time decay
Inception
Maturity
Time decay consists of (a) positive carry from asset side credit risk & liability benefit and (b) vega of the underlying market factors These are offset from (a) buying CDS and (b) buying options on underlying market factors As the MTM goes deep in-the money positive (or deep out-of-the money negative, the time decay split shifts from (b) to (a).
T=0
After an FX Move FX 1.3600 5y Credit 93 CVA 403 FX + 100 1.3700 Sensitivity to FX Moves CVA FX01 424 21 Hedge 2100 CR + 10 103 Sensitivity to Credit Curve Moves CVA CR01 Hedge 443 40 8,000 CVA (21) PnL FX Hedge Credit Hedge 21 0
T=0
Now Credit Curve Moves FX 1.3600 5y Credit 103 CVA 443 FX + 100 1.3700 Sensitivity to FX Moves CVA FX01 466 23 Hedge 2300 CR + 10 113 Sensitivity to Credit Curve Moves CVA CR01 Hedge 483 40 8,000 CVA (40) PnL FX Hedge Credit Hedge 0 40
T=0
FX and Credit Curve Move Simultaneously FX 1.3700 5y Credit 113 CVA 508 FX + 100 1.3800 Sensitivity to FX Moves CVA FX01 534 26 Hedge 2600 CR + 10 123 Sensitivity to Credit Curve Moves CVA CR01 Hedge 550 42 8,400 CVA (65) PnL FX Hedge Credit Hedge 23 40
T=0
FX and Credit Curve Moves Simultaneously FX 1.3800 5y Credit 123 CVA 578 FX + 100 1.3900 Sensitivity to FX Moves CVA FX01 607 29 Hedge 2900 CR + 10 133 Sensitivity to Credit Curve Moves CVA CR01 Hedge 621 43 8,600 CVA (70) PnL FX Hedge Credit Hedge 26 42
T=0
T=0
FX and Credit Stay Constant, Time Passes FX 1.3500 5y Credit 93 CVA 258 FX + 100 1.3600 Sensitivity to FX Moves CVA FX01 274 16 Hedge 1600 CR + 10 103 Sensitivity to Credit Curve Moves CVA CR01 Hedge 286 28 5,600
CVA 124 PnL FX Hedge Credit Hedge 0 0
T = 1Y
FX and Credit Stay Constant, Time Passes FX 1.3500 5y Credit 93 CVA 158 FX + 100 1.3600 Sensitivity to FX Moves CVA FX01 169 11 Hedge 1100 CR + 10 103 Sensitivity to Credit Curve Moves CVA CR01 Hedge 176 18 3,600
CVA 100 PnL FX Hedge Credit Hedge 0 0
T = 2Y
FX and Credit Stay Constant, Time Passes FX 1.3500 5y Credit 93 CVA 85 FX + 100 1.3600 Sensitivity to FX Moves CVA FX01 92 7 Hedge 700 CR + 10 103 Sensitivity to Credit Curve Moves CVA CR01 Hedge 95 10 2,000
CVA 73 PnL FX Hedge Credit Hedge 0 0
T = 3Y
FX and Credit Stay Constant, Time Passes FX 1.3500 5y Credit 93 CVA 30 FX + 100 1.3600 Sensitivity to FX Moves CVA FX01 34 4 Hedge 400 CR + 10 103 Sensitivity to Credit Curve Moves CVA CR01 Hedge 34 4 800
CVA 55 PnL FX Hedge Credit Hedge 0 0
T = 4Y
FX and Credit Stay Constant, Time Passes FX 1.3500 5y Credit 93 CVA 0 FX + 100 1.3600 Sensitivity to FX Moves CVA FX01 0 0 Hedge 0 CR + 10 103 Sensitivity to Credit Curve Moves CVA CR01 Hedge 0 0 0
CVA 30 PnL FX Hedge Credit Hedge 0 0
T = 5Y
Residual Risks
Liquidity Risk Covers transaction cost including bid/offer spread and the sudden widening of bid/offer spread due to lack of liquidity. Recovery Risk Covers the risk of the obligations recovery value upon a counterparty default. E.g. Recovery locks. Gap Risk (Cross Gamma) Covers the risk of a simultaneous move in credit and the underlying FX, IR or Equity rates. Correlation Risk Covers the correlation assumed in the model and the change in correlation between credit and the underlying. Model Risk - Covers uncertainty in the model vs the actual market for unwind. Legal, netting and Documentation risk Covers the legal and netting effectiveness of the CDS hedge and the enforceability of the ISDA swap documentation in various jurisdictions.
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