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2012 IBM Corporation

Managing Counterparty Credit Risk:

Implementing Real Time CVA Pricing

Dr. Neil Dodgson

VP Business Development Sell Side

February 2012


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Banking reforms

BaselIII

Credit Exposure

CVA Price FVA Charge

CVA ChargeIRC

Stressed VaR

VaR CVAWWR

EPE

Sensitivities

Fair ValuationRAPM

RWA

Liquidity

Funding

ALM

LCR

Capital Ratio

Market Exposure

Planning

NSFR

Collateral

Risk Management

Treasury

Finance

Front Office

2012 IBM Corporation2


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How is Basel III affecting counterparty credit risk?

Capital requirement for counterparty credit risk using stressed EPE

CVA calculations

Margin period of risk for collateral management

Central counterparties

Wrong-way risk



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CCR/CVA timeline

Before CVA

Firms apply credit limits and

measures such as to limit their

possible exposure to a

counterparty in the future

1998: Asian crisis and Long-

Term Capital Management

(LTCM). The unexpectedfailure of the large hedge

fund LTCM and Asian crisis

lead to an interest in CCR

from some first tier banks

Passive Management of CVA

Large banks first start using CVA to

assess the cost of counterparty risk

CVA is treated via a passive

insurance-style approach

Active Management of CVA

The credit crisis and resulting failures of

high profile firms generates much more

attention on counterparty riskBanks are interested in more accurate andevermore frequent CVA calculations daily,

intra-day, and real-time

2006: New Accountancy

regulations(FASB 157, IAS 39)

mean that the value of

derivatives positions must be

corrected for counterparty risk

All banks must start calculating

CVA on a monthly basis

Sept. 10-15, 2008: Lehman

Brothers collapses following a

reported $4 billion loss andunsuccessful negotiation to find a

buyer, one of Wall Streets most

prestigious firms files for

bankruptcy protection

In only a few short years, we have seen a shift from passive to more

active and cont inuous management of CCR requiring CVA:



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Before the credit crisis

Mostcounterparty risk situations were rather unilateral

The too big too fail concept obscured counterparty risk

Many institutions see their counterparty as being risk-free (at least from their point

of view)

Credit spreads of banks just a few bps Collateral agreements often one-sided or heavily skewed (independent amounts

etc.)

Counterparty risk was the focus of mainly large global banks (1st tier)

Wrong-way risk was a concept rather than a reality

No-one had ever heard of DVA

Risk is changing



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Counterparty credit risk - a front office issue

Capital Markets

Solution for active management of count erparty cr edit risk

Credit exposure calculation Simulated PFE exposures

Notional and add-on measures

Stress testing

What if analysis

CVA calculationUnilateral and bilateral Pre-deal incremental CVA

CVA sensitivities

RISK MANAGEMENTFRONT OFFICE /CVA DESKTRADING

FINANCE

Limit managementPre deal limit checking Trade restrictions &

limits

Intra day excess



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Users Function Requirements

Front office Trading and sales charge clients andcustomers for CVA.

May influence trade or counterparty

Trade within limit structures

Calculate pre deal exposure and

incremental CVA as amount for deal. Want

portfolio effect (deal and at netting level).

Central CVA Desk Charge trading desks

Compute internal insurance cost

Optimizer risk/return via hedging

CVA per counterparty for initial charge

CVA per deal if advising

CVA sensitivities

Risk Management Monitor and interact with ON CCR and CVA

Trader compensation includes CVA charger

Monitor risk intraday, on demand risk, what-

ifs

Use baseline for risk monitoring

Use intraday updates for interacting

Run analysis with new trades and new

scenarios

Finance Comply with regulation (e.g., FASB 157)

Calculate fair value of derivative portfolio

End of quarter CVA, or CVA -DVA

Counterparty credit risk



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Calculating the CVA of a derivative is alwaysmore complex than pricing the

derivative itself

e.g., CVA of a swap involves volatility, but pricing the swap itself does not

Must account for

Complexities of the trade (cash flows, exercises, resets, ) and market variables

Correlations between market variables

Default probability and recovery value (often more art than science)

Netting (causes exposure to be reduced)

Collateral agreements (as above)

Wrong-way risk (credit derivatives in particular)

Why is CVA so complex?



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Current practice: transition to active management

Of the firms surveyed, 50% calculate CVA monthly, 25% daily, and 25%

in real time

Source: Credit Value Adjustment: and the changing environment for pricing and managing counterparty risk, Algorithmics, December 2009



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Pre credit crisis: firms that charged CVA were often at a pricing

disadvantage relative to firms that did notPost credit crisis: firms that charge CVA on an incremental basis are a

competitive advantage vs. firms that cannot

Current practice: incremental CVA at deal time

Source: Credit Value Adjustment: and the changing environment for pricing and managing

counterparty risk, Algorithmics, December 2009



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Survey : CVA purpose and management of CVA

The main purpose of CVA today is to facilitate accounting reporting, followed by front

office pricing:

In the front office, CVA is owned by either a single front office unit (58%), in multiple

groups (25%), or in a single risk group (17%).

50% calculate CVA monthly, 25% daily, and 25% in real time

Source: Credit Value Adjustment: and the changing environment for pricing and managing counterparty risk,Algorithmics, December 2009



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It is typical to assume independence between

Default probability of counterparty

Exposure at default

But, in reality, this is often wrong

Buying out of the money put options

Buying CDS protection

FX products with local currencies

Wrong way risk challenges

Correlation and dependency are not the same thing

Wrong-way risk might be quite subtle / indirect

Wrong-way risk can be massive (mono-lines)

Wrong-way risk



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Corporate Portfolio

150 Swaps: one-directional (long fixed/short floating), alldenominated in CAD

Maturities: min = 2wks, max = 10yrs

Market factors: short-rate calibrated to swaption vols Credit modeling: no netting, no collateral

Simulation time steps: quarterly to 10yrs (total of 40)

A realistic example: why wrong-way risk matters (example 1)



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-1,000

0

1,000

2,000

3,000

4,000

5,000

6,000

-1 -0.75 -0.5 -0.25 0 0.25 0.5 0.75 1

CVA depending on correlation

A realistic example: why wrong way risk matters (example 2)

Wrong way

Right way

CVA goes from $1.7M - $5M, depending on right or wrong way risk

Corporate Portfolio



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Portfolio credit risk framework



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Wrong-way risk

Joint simulation of market and credit risk factors

Market, systemic & specific risk factors

Utilises existing economic capital models

Migrations and defaults modelled

Reduced number of micro/macro factors

Conditional scenarios

Enhanced performance

SpecificCredit

MarketFactors

SystemicCredit



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1MARKET RISK FACTOR SCENARIO GENERATION

3AGGREGATION & NETTING

2POSITION VALUATION

5 OBTAIN EXPOSURE PROFILE FOR EACH SCENARIO

6 OBTAIN EXPOSURE METRICS

4 COLLATERAL ADJUSTMENT

Credit exposure modeling: Monte Carlo simulation approach



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1

MARKET RISK FACTOR SCENARIO GENERATION

CVA Use Risk Neutral Scenarios

3AGGREGATION & NETTING

2POSITION VALUATION

5 OBTAIN EXPOSURE PROFILE FOR EACH SCENARIO

6OBTAIN EXPOSURE METRICS

CVA - Calculate Discounted Expected Exposure

4 COLLATERAL ADJUSTMENT

CVA: Natural extension of credit exposure modeling



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CVA desk: day in the life

Pre-Deal

Calculate incremental impact of new trade on market and counterparty exposure,compare to limits

Calculate incremental impact of new trades on CVA, use this information for pricing

Manage excesses

Intra-day Update market and credit exposure profiles to include impact of new trades, as trades

are booked

Investigate counterparty exposures

Ad-hoc stress tests on market factors, CSA parameters, modeling assumptions

End-of-Day Measure market and counterparty exposures for limit and reporting purposes,

including VaR, stress tests and counterparty PFE (shortfall above 90%), and CVA Model counterparty portfolio diversification, netting, and collateral

Cover all trades including exotics

Calculate CVA across market scenarios to hedge P/L volatility

Manage excesses



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Positioning of CVA desk

Centralised or decentralised

Profit centre or utility

Hedging policy

Basis, proxies, liquidity, market gaps

Overtrading due to unstable sensitivities

Divergence between business practice and regulation (Basel III)

DVA (Debt Value Adjustment)

Should you monetise your own default?

Link to funding

Wrong-way risk

How to minimizewrong-way risk

How to create right way exposures

Tight operational integration and fast analytics are both essential

CVA desk: key challenges



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CVA sensitivities

Credit

FX

Rates

Commodities

Equities

Volatility

Correlation

Cross gamma sensitivities

Fullsimulation approach

High performance computing



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Case study equity derivatives

RESULTS - EQUITY

All counterparties (PFE) 38% reduction

Top 5 counterparties (PFE) 53% reduction

CVA No model was used to calculate the

value before

Combined exposures simulated 10% of the counterparties shared

PERFORMANCE - EQUITY

End-of-day elapsed time 2 hours

Grid nodes 48 engines / 6 machines

Computational time 18 CPU hours



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What are we seeing?

CVA is calculated in middle office/finance

CVA desks being established

Real time CVA pricing (sub second response time)

CVA sensitivities (over 100 sensitivities required)

Capital charge affect on RWAs

Liquidity/funding value adjustment



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CVA enables, in fact, requiresa strategic change in risk culture and

practice. It needs to fit within a broader business vision.

CVA should be managed actively: CVA desk

Short cuts will not work: wrong way risk

Best practice implementations are achievable they are about both,

tight operational integration and fastandaccurateanalytics

CCR and CVA approaches need to be consistent and should leverage

each other. Regulatory CVA is a separate stream.

Summary

2012 IBM C ti29

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