Sep 25, 2013

Practical CVA/FVA Calculations:

Complexity and Challenges
Presented by Dongsheng Lu, Managing Director

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Consistent Accounting

V Fair

V FC CVA

Terms

V Fair

V FC

CVA

FVA

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FVA
Explanation

Fair Valuation of financial Instrument

Valuation under fully-collateral assumption
Credit Value Adjustment
One way CVA
Funding Value Adjustment
Funding cost and benefits

Credit and Funding Concepts

CVA/FVA: both coming from borrowing/lending. Default vs funding.

Base: Perfect credit, fully collateralized cash
CVA: credit default only
FVA: anything related to funding, value of collateral, cost of posting collateral,

Bond spread vs CDS: funded vs non-funded default spread

u: cpty default risk

u
u
X=u+L
L

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Funding: Balance sheet and Borrowing

Capital

Equity

Businesses

Debt Issues

and

Securities

Investments

Asset

Financial institutions rely heavily on

borrowing and are highly leveraged.
The better capitalized, the higher the credit
rating.
Firms funding level represents
market/investors view on firms credit as well
as market liquidity

Firms Funding activities:

Liability

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Deposits
Issue debt
Issue equity
Convertible bond
Funding centers
Practical difficulty to compare different
funding activities

Unsecured Lending/Borrowing
Lend $1

Cpty

t=0

t=T

Lend $1

Lend $1

Funding
Desk

LOB

FundDesk
Borrowing

Market
Lending

CPTY
Borrowing

LOB
Lending

LOB
Borrowing

$1

-$1

$1

-$1

$1

-$1

-$1.2

$1.2

-$1.1

$1.1

-$1.1

$1.1

Derivative Activity
(CVA/DVA/FVA)

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FundDesk
Lending

Market
Lender

Internal Funding
Transfer

External
Borrowing

Assumptions
Applies to financial institutions with high leverage
At any given time, there is an equilibrium funding cost for the firm. Assuming the
existence of a funding curve.
Funding policy and operations varies from firm to firm
Given a policy and funding curve

Firm should be marking the future cash flow exactly the same way, whether it is
issued debt or swaps or complex derivatives
Debt issuance spread would give the funding level across maturities
Funding spread include: Firms credit, Markets liquidity
The same discounting should be applied for derivatives

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Assumptions
There is one true economic value for each market participant for a given trade
Every market participants economic value could be different for the same trade
Different valuation reflects the competitiveness of the market participants
Market Price Markets average exit value
same way as LIBOR as average funding rate
Valued based on average funding rate
Funding value adjustment (FVA) depends on how one treats all other adjustments
A lot of confusion as to what is FVA
It is a relative value
Base: Fully collateralized. Base + Credit + Funding
Funding value adjustment Collateral value Part of discounting spread

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FVA Debate: FVA in Fair Valuations?

Borrow(-)/Lend(+)

Individual
Businesses

LOB1

+++

LOB2

++

LOB3

*
*
*

LOBn

Total Funding Requirement:

Sum of funding cost/benefit

*
*
*

---

Given funding spread X at firm level, all LOBs mark book based on X
The sum of funding/cost reflect the total funding requirements at the firm level
Funding from outside at firm level balanced with sum of all LOBs funding needs
Individual business level funding X marking Equivalent Market value for LOBs +
apply funding X at the firm level
Proper incentive for the individual businesses

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FVA Debate: FVA in Fair Valuations?

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Aggregated Short/Medium/Long term

funding needs

Ideally matched funding needs and

actual outside funding

Reality Short/Medium term funding

liability/borrowing Longer term
asset/lending

Regulations more balanced

asset/liability matching in terms

Funding cost should be charged at

the individual LOB level to reflect the
proper incentive.

Market change: for example, S&P

500 index total return
(LIBOR+30/40bps from close to
LIBOR flat)

Typical Client Quoting with CVA/FVA

LCH

LCH Pricing

Margin rule +
Incrementl Risk

LCH /
CME ?
CME Pricing
CME

CCP

Differential
Discounting
Pricing

Secured Pricing
CSA / CCP?

YES

CSA

CVA ~ 0
Collateral asset
Collateral CCY

Fully
Collateralized?

SCEN

Other Pricing Terms

Market Hedging Cost

Credit Hedging Cost
Capital/Balance sheet Charge
Profit Margin

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NO

Collateralized
Portion

CSA Pricing
Collateral
Thrshld
Rating Trigger
Break Clause

Un-collateralized
Portion

SCEN

CVA
Funding
Cost/Benefit

Differential Discounting
Basic Funding Spread Curves
Differential Discounting
Classify all funding
situations, construct
funding curves

Base discounting: e.g. USD Collateral

Different Currency
Different Asset
Construct Funding spread curve

Collateral Currency
Xccy spread curve
Optimal xccy funding

Collateral Asset
Cash/Treasury
Agency GSE
Corporates
Munis

Break Clause

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Dynamic Funding Curve Generation

Max(FND1,FND2, FNDN)

A Typical Example: JPY Swaption Trading

Differentiate Collateral: JPY or USD or CSA, differential discounting
Differentiate Underlying swap: LCH/CCP or CSA
- LCH Swap: central cleared swap
- CSA: different assumptions
- Complex situation: mixture discounting CSA+LCH
Forward vs Spot premiums
Physical vs Cash settlement
Customer trading: CVA, FVA, Capital

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Example:
A CSA governed Swaption settle into LCH Swap

CSA
Discounting

t=0

LCH Swap:
OIS Discounting
Option
Expiry

Swap
Maturity

Mixture Discounting Example

Before option expiry, economics follow CSA discounting

After option expiry, settle into LCH swap, native OIS discounting

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Example:
Break/Trigger/Exit Clause/Mutual Put/Replacement

Credit Risk
Exposure

No Credit risk
Break
Date 1

t=0

Deal
Maturity

Mutual Put, Break/Trigger Clause

CVA: No Credit risk after break date, limited tenor risk paid at day one
FVA: Discounting for cashflow after break date is ambiguous
FVA: Average market funding is LIBOR?
Replacement event ?

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Scenario Based CVA/FVA Calculation

Trigger/Exit
Triggered?

No Credit risk after trigger

Exiting value calc (LIBOR)
Replacement cost

Scenario Based Pricing

Collateralized: Max(-V-H,0)

Rating based threshold

Collateral discounting

scenario rating
scenario valuation
scenario threshold

Unsecured: -Min(-V,H)
V<0

No DVA
Fund Benefit: Min(-V,H)*X*dt

Rating Trigger
scenario triggered?
Break Clause

Collateralized: Max(V-H,0)
V>0

No CVA
Collateral Discounting

Unsecured: Min(V,H)
Credit Exposure: Min(V,H)
CVA: Min(V,H)*u*dt
Funding cost: Min(V,H)*X*dt

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Scenario Based CVA/FVA Calculation

Market Simulations (M)
(e.g. 10,000 paths)

CSA

Exposure
Credit

Aggregation
Funding

CVA
FVA

Credit

Credit Simulations (C)

(e.g. 100,000 paths)

Capital Requirement:
Counterparty Credit risk (Basel II)
CVA VaR based (Basel III)
Advanced/Standardized approach

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Challenge: Complex CSAs

Rating Migration

Break/Default Clause

Rating Based Threshold

Downgrade events
Replacement cost

Collateral Definition
Collateral Asset
Collateral Currency
Hair Cut
Initial margins
Collateral Damage

Mutual put
Termination event (ATE)
Legal/Netting

Need scenario based credit

Credit simulation with migration
Apply CSA in scenarios

Additional Exit Event

No credit risk after exit
Funding cost calculation
Exit event vs market liquidity

Collateral Modeling
Collateral choice: static funding
curve. Optionality impractical.
Hair cuts/Margins

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Challenge: Massive Computations

Market Risk
Any market risk within the normal
derivatives pricing/risk management are
risks for CVA/FVA, including rates, FX,
stock price, volatility/skew and
correlations etc .

Live Trading
Live Pricing/Quoting
Incremental CVA/FVA Calc

Credit Risk
Specific Name risk
Generic credit risk
Downgrade/Default risk
Hedging strategy

Wrong Way Risk

Specific counterparty WWR
WWR hedge

Capital Requirement
CVA VaR
BASEL III Capital
Standardize vs Advanced methodology

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Pricing,
Risk Management,
Hedging and
Perf Measurement

Challenge: Massive Computations

Market Risk
Price Levels, delta/gamma
Rates/delta buckets, gamma ladder
Basis (Libor basis, xccy basis etc) buckets
Vega distribution/Skew exposure
Correlation levels

Scenarios
Generation

Credit Risk
Specific Name credit buckets
Generic Index credit buckets, hedge ratio
Proxy hedges, hedge ratio

Each Scenario
Market, Credit
Simulations, and
Aggregations

Wrong Way Risk

Different Correlation levels
Factor based WWR

Regularoty Requirement
Credit sensitivities for CVA VaR
Stress testing: market and credit

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Sensitivities
Buckets
Hedge Ratio etc

Challenge: Massive Computations

Scenarios
Generation

Each Scenario
Market, Credit
Simulations, and
Aggregations

Efficient Computing
Efficient CVA/FVA computation
design
Adjoint Algorithmic Differentiation

Node

Node

Node

Node

Node

Distributed Computing
Sensitivities
Buckets
Hedge Ratio etc

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GRID Computing
GPU Computing

CVA/FVA Calculations
Backward Pricing: credit/funded discounting

CVA / FVA V ( risky / funded ) V ( riskfree / unfund )

Credit Discounting: (similarly for funded discounting)

e ( r u ) t e rt 1 (1 R ) P d

Forward Simulation: collecting defaults and funding cost/benefits

T

CVA

E ( t )( 1 R ) P d ( t ) D ( t ) dt

FVA

E ( t ) X ( t ) D ( t ) dt

E(t): Exposure at risk at time t

D(t): discounting
X(t): funding spread

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Backward Discounting:
Pros:
Easy to incorporate spread impact
Can incorporate credit impact on exercise boundary

Cons:
Difficult to net portfolio of deals with same CSA
Difficult to apply more complex CSA terms
Difficult to calculate wrong way risk, incremental CVA

Forward Simulation:
Pros:
Can net portfolio deals across same CSA easily
Can deal with very complex CSA terms easily
Fast computation of wrong way risk and incremental CVA

Cons:
Need to develop a global simulation model and a complex correlation model
Approximation: exercise boundary not affected by credit/funding

CVA/FVA Calculations
Forward Simulations Steps
Consistent multicurrency/asset simulations (IR, FX, Equity )
Along with credit simulations + ratings transition
Valuation of all instruments once market factor exposure
Aggregation of market factor exposure with credit/ratings
Application of netting and CSA
Collect default loss and funding cost/benefits

CSA Complexity

Rating dependency of collateral posting

Downgrade provisions
Collateral asset/currencies
Automatic/Discretionary terminations
Legal/Netting opinion

Credit Rating

Collateral
Threshold

AAA

50M

AA

20M

5M

BBB

0M

Credit Rating

Event

BBB

Termination

Eligible Currencies
USD
EUR
GBP

CSA Complexity Modeling

Needs to model ratings in the future
Market risk simulation and credit
simulations at the same time
Correlations could become important

Asset

Haircut

Cash

100%

Treasury < 2y

101%

Treasury (2y-5y)

103%

Treasury(5y-10y)

105%

Treasury(>10y)

108%

GSE
Passthroughs

115%

Corprts/Munis

120%

Challenge: CSA Netting with Complex Portfolio

Generic Time Grid

Generic Time Grid

Specific Trade Pricing:

Trade specific Cashflows, Resets, Notifications, Exercise etc
Requires a trade specific time grid
Different grid for different deals

Specifc Time grid For Deal j

Specifc Time grid For Deal k

Methodology 1:
Market factor calculations based on trade specific grid
Regression/interpolation of scenario valuations:
V = V(R,t), R: regression variables
Use regressed/interpolated values on generic grid/scenarios Exposures
Aggregation of market factor exposures with credit/ratings

Methodology 2:
Direct valuations based on trade specific grid: simulation based (such as BGM)
Exposures are obtained for trade specific grid
Interpolate market factor exposures from trade specific grids to generic grid

Methodology 1:
Pros:

Can use any trading quality pricing model regression

Cons:
Accuracy of regression/interpolation: explanatory variables and power

Methodology 2:
Pros:

Consistency can be built among all market risk factors

Cons:
Need to develop a global simulation model
Need consistent correlations among risk factors and for all trades.

Random number Mapping

Random number for generic time grid => derive trade specific grid RN
Conserve correlation: equivalent random number generation

Known

Need

dt

dt

dz

dz
dz

Black:
Orange:

Generic Time Grid

Trade Specific Grid

Brownian Bridging Random Number

Known

dt

dt

dz

dz

Need

Adding random numbers:

Correlation Conserved:

dz

Black:
Orange:

Generic Time Grid

Trade Specific Grid

Challenge: Credit Simulation and Ratings Migration

Credit simulation:

Aggregation vs market valuations

Requires correlations among Market and Credit risk factors
Use generic time grid
CVA = Credit_Aggregation(CSA, Credit Ratings, Market Values)
FVA = Funding_Agg(CSA, Credit Ratings, Market Values, Funding Spread)

Generic Time Grid

Credit Simulation
Methodology 1:
Simulate credit spreads in scenarios
Map credit spreads to ratings credit migrations

Methodology 2:
Structural model simulation using ratings transition matrix
Risk neutralization of transition matrix
Defaults from ratings migration calibrated to market traded CDS

Credit Simulation: Finite Markov Process + Ratings Transition

Default
C

Dynamic
simulation

B
A
AA
AAA

Rating i

Rating k

Rating j

Rating m

Structural asset model

Based on a N-rating system.
Probability of defaults calibrated step-wise

Credit Simulation: Transition Matrix Propagation

p11

p21
~
p
...

p12

...

p22 ...
... ...
0

...

p1n

p2 n
...

Credit Simulation: Transition Matrix Propagation

p11

p21
~
p
...

p12

...

p22 ...
...
0
t=1

...
...

p1n P1T p11T

T T
p2 n P2 p21

...

...

1 PnT 0

p12T ...
T
p22
...
...
0

t=T

...
...

p1Tn

T
p2 n
...
1

Credit Default: Jump to default and Transition to Default

AAA

AA

BBB

Credit Calibration: Generic Stepwise Transition Matrix Calibration

p 1i n 1

i 1
~ p2n
Pt i
...
p i 1
nn

Pd 1 i 1

Pd 2 i 1

...
P i1
dn

Risk Neutralizing Markovian Transition Matrix

P(Default)

0.31%

1.72%

6.28%

0.72%

4.27%

11.80%

2.60%

13.00%

25.60%

10

7.00%

30.00%

48.00%

TMatrix(Annnual)

96.0%

2.50%

1.19%

0.31%

0.40%

83.0%

14.87%

1.73%

0.41%

1.00%

92.3%

6.29%

0.00%

0.00%

0.00%

100%

Credit Simulation: Structural Asset Model and Calibration

Exact Calibration to specific name CDS

p 1i n 1

i 1
~ p2n
Pt i
...
p i 1
nn

Pd 1 i 1

Pd 2 i 1

...
P i1
dn

Specific name calibration after generic TM calibration

From generic TM calibration, probability of default not calibrated exactly
In this calibration process, default probabilities are adjusted to match CDS
exactly
One can assign partial default to scenarios to match default exactly

Wrong Way Risk: Market/Credit Correlation Stress)

Base Scenario

Market/Credit
Correlation Stress

Correlations

Market Factors
Keeping same market factor exposure

Credit Factors
Solving credit factors incrementally

Credit Risk Hedging with Rating Trigger

AAA

AA

BBB

Credit Rating

Collateral
Threshold

AAA

50M

AA

20M

5M

BBB

0M

Credit Rating

Event

BBB

Termination

Incremental CVA Calculations

Incremental CVA Calculation for a New Deal

Given exposure V(ijk) for portfolio

Calculate single deal exposure U(ijk)
Portfolio CVA = Agg(credit, V)
New Portfolio CVA = Agg(Credit, U+V)
Incremental CVA = CVA-CVA
Credit aggregation: fast process

Incremental CVA Calculation for a Existing Deal

Given exposure V(ijk) for portfolio

Calculate single deal exposure U(ijk)
Portfolio CVA = Agg(credit, V)
Portfolio without deal CVA = Agg(credit,V-U)
Incremental CVA = CVA-CVA