In Sight Quantifi Newsletter Issue 02


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Insightful newsletter featuring how to overcome the challenges of Counterparty Risk Management

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In Sight Quantifi Newsletter Issue 02

  1. 1. INNEWSLETTER ISSUE 02 SIGHT 2011 Waiting for CVA? OvERCOMINg THE CHALLENgES of Counterparty Risk Management Also in this issue: Survey: How do you Manage your Counterparty Credit Risk? Page 3 OIS and CSA Discounting Page 6
  2. 2. MeSSAGe NeWSfROM Client News:THe CeO CM10-CIC Selects Quantifi One of the largest banking groups in france sought a powerful and advanced pricing and structuring tool. ComparedThe global financial markets are experiencing major changes to the competitive solutions, Quantifi XLwith new regulations and the impending Basel III capital proved to fit all necessary requirements.accord. While there is significant uncertainty about key “Quantifi has a strong track record in thisdetails of final regulations and implementation timelines, space and we expect to see significantthere is a growing consensus and direction emerging for benefits as we now have access to aa new OTC market landscape. Key drivers of this new proven solution that matches prices inlandscape include counterparty risk, a new valuation the market combined with responsiveframework adjusting for the cost of collateral agreements support.” Senior Derivatives Tradercalled OIS discounting and central clearing. Linda Kessour, CM-CIC MarchésQuantifi is focused on what is important to our clients and is CIMB Investment Bank Selects Quantifileading the market in developing solutions tailored for this new Malaysia’s largest investment bankOTC market landscape. In addition to a significant investment selected Quantifi XL, based on speed,in product development, as demonstrated by our QX.1 release accuracy and flexibility, to supportscheduled for this quarter, we have also published two recent its expanding operations. ”Securingthought leadership pieces on the challenges of counterparty CIMB as a client is excellent news and arisk implementation and derivatives valuation using OIS welcome addition to our growing clientdiscounting. The goal is to engage clients and the market base both within the investment bankingin the ongoing discussion around trends and best practices. sector and across Asia.”One important example of this engagement is our upcoming Rohan Douglas, CeO, Quantifiseminar in London co-hosted with PRMIA where leading Sterne Agee Selects Quantifiindustry practitioners and regulators will be joined by market for the largest privately owned broker-participants in a forum for discussion and sharing of ideas dealer in North America, Quantifi XLaround counterparty risk and CVA. has proved to be the ideal solution, providing traders and salespeople withThrough the first half of 2011 we have seen a continued pickup immediate access to advanced pricingin the OTC markets as evidenced by a host of new clients and deal analysis at a fraction of the costincluding CM 10-CIC, Sterne Agee and CIMB. We see the entry of an internal build. Sterne Agee realisesof new participants and an increase in risk appetite reflected an immediate competitive advantageby a dramatic increase in the depth of the credit index options by rapidly scaling their business andmarket. We have also seen a rapid evolution and convergence competing on a level playing field within the counterparty risk space towards that of the largest banks the most sophisticated global banks.and what we consider market best practice.I look forward to an exciting second half of 2011 in what is Product News:turning into a seminal year for the OTC markets. CDS Index Option Models Quantifi enhances its credit index option models in response to client demand for more sophisticated analysis and to support for the latest market developments. “We have been working closely with clients to develop flexible tools for pricing CDS index options, consistent with techniques used in other markets. WeROHAN DOUGLAS, Founder and CEO have implemented tools to calibrate credit volatilities used in CVA pricing and hedging from CDS index option quotes.” David Kelly, Director of Credit Products, Quantifi02 |
  3. 3. QUANTIfI SURVeyHow do you manage yourCOUNTERPARTy CREDIT RISk?Quantifi recently exhibited at the Global Derivatives and Risk Management conference in Paris and surveyed a crosssection of financial firms on the topic of counterparty credit risk. The purpose of the survey was to gain an insight intothe various approaches and timing in implementing counterparty risk management processes. This report highlights thekey preliminary findings1.Managing Counterparty Credit Risk Another significant challenge is the calculation of CVA27% of firms actively manage and hedge CVA. 59% of sensitivities due to significant computational andfirms use exposure limits and 50% use counterparty numerical complexities. Although many respondentsselection as their primary method for counterparty are not hedging CVA, the importance of CVAcredit risk management. sensitivities reflects the trend towards this goal.The trend is towards active management, as hedging Technology InitiativesCVA is becoming increasingly important to offset 31% of firms are currently implementing of evaluatingsignificantly higher regulatory capital requirements and vendor counterparty risk and CVA systems.the impact of CVA volatility on earnings. For many banks that have not yet implementedTiming of Major Changes counterparty risk management systems, a newAll respondents have or plan to implement major generation of vendor systems can provide a fast andchanges in their counterparty risk systems. 41% of effective solution with reduced maintenance costs.respondents plan to complete major changes in Key considerations for successful implementation2012 or beyond. of a vendor solution include the number of systemsAs outlined in Quantifi’s recent whitepaper - ‘Challenges that must be integrated, data sourcing and formatin Implementing a Counterparty Risk Management conversions, and the ability to add proprietary models.Process’ - the data, technological and operationalchallenges can be significant and contribute toextended implementation timelines. Key findingsCalculating CVA for New Trades • 27% of firms actively manage and hedge CVA.64% of respondents calculate CVA on new trades. 59% of firms use exposure limits and 50% use50% of these use an integrated calculator with counterparty selection as their primary methodnetting and collateral. for counterparty credit risk management.It is expected that the number of firms that calculate • All respondents have or plan to implementmarginal CVA on new trades, reflecting netting and major changes in their counterparty riskcollateral, will continue to grow and evolve to near systems. 41% of respondents plan toreal-time pricing. complete major changes in 2012 or beyond.Key Issues with existing Counterparty Risk Systems • 64% of respondents calculate CVA on new trades. 50% of these use an integratedThe largest challenge within existing counterparty calculator with netting and collateral.risk systems is data management and integration(64%). The next largest challenge is the calculation • The largest challenge within existingof CVA sensitivities. counterparty risk systems is data management and integration (64%). The next largestData management and integration is the most challenge is the calculation of CVA sensitivities.widespread issue which reflects the diversity ofsystems within most firms and the challenges around • 31% of firms are currently implementingintegration and management of transaction, market or evaluating vendor counterparty riskand reference data. and CVA systems.1 A number of respondents selected multiple answers | 03
  4. 4. COVeR STORy Waiting for CVA? OvERCOMINg THE CHALLENgES of Counterparty Risk Management by DAVID KeLLy, Director of Credit at QuantifiMost banks are in the process of setting up counterparty the bank’s own default. While clearing and collateral arerisk management processes or improving existing the principal means for managing counterparty risk inones. Counterparty risk is increasingly being priced and the inter-bank market, uncollateralised exposure is moremanaged by a central CvA desk or risk control group prevalent in the corporate derivatives market and bankssince the exposure tends to span multiple asset classes compete aggressively on CvA pricing. CvA pricing isand business lines. Moreover, aggregated counterparty inherently complex for two reasons. First, the incrementalexposure may be significantly impacted by collateral and (or marginal) CvA for each trade should reflect thecross-product netting agreements. application of collateral and netting agreements across all transactions with that counterparty. Second, CvA pricinggathering transaction and market data from potentially models not only need to incorporate all of the risk factorsmany trading systems, along with legal agreements of the underlying instrument, but also the counterparty’sand other reference data, involves significant and often ‘option’ to default and the correlation between the defaultunderestimated data management issues. The ability to probability and the exposure, i.e., right- or wrong-way risk.calculate credit value adjustments (CvA) and exposuremetrics on the entire portfolio, incorporating all relevant given the complexity, two problems arise. Somerisk factors, adds substantial analytical and technological banks are not able to compete for lucrative corporatechallenges. Furthermore, traders and salespeople expect derivatives transactions because they do not take fullnear real-time performance of incremental CvA pricing of advantage of collateral and netting agreements withnew transactions. Internal counterparty risk management their counterparties in calculating CvA. Or, they winmust also be integrated with regulatory processes. transactions because their models under-price some of the risks and subject the bank to losses. The complexity isIn short, the data, technological, and operational compounded by the need for derivatives salespeople tochallenges involved in implementing a counterparty risk make an executable price in near process can be overwhelming. While CvA covers the expected loss from counterpartyCVA & Capital: CvA is the amount banks charge their defaults, economic or regulatory capital provides acounterparties to compensate for the expected loss from buffer against unexpected losses. Subject to approval,default. Since both counterparties can default, the net the Internal Model Method (IMM) specified in the Baselcharge should theoretically be the bilateral CvA, which accord allows banks to use their own models to calculateincludes a debt value adjustment (DvA) or gain from regulatory capital. The total regulatory capital charge for04 |
  5. 5. counterparty risk is the sum of the counterparty default of aggregating risks across business lines excessivelyrisk charge and CvA risk capital charge. The counterparty complicated. Continuous development of new typesdefault risk charge is calculated using current market data, of derivative payoffs and structured products haseither implied or calibrated from historical data. Three- exacerbated the problem. But the failures and nearyears of historical data are required, including a period of failures of several global banks have changed thestress to counterparty credit spreads. The CvA risk capital traditional mentality. Banks are now taking a ‘top-down’charge was introduced in Basel III, as CvA losses were approach to risk management. Decision-making authoritygreater than unexpected losses in many cases during the is transitioning from the front-office to central market andrecent crisis. The charge is the sum of the non-stressed credit risk management groups.and stressed CvA vaR, based on changes in creditspreads over a three-year period. Eligible credit hedges A key component of the top-down approach to riskcan be included to reduce the total capital charge and management is the central CvA desk or counterparty riskcleared transactions may be omitted. group. In practice, the CvA desk sells credit protection to the originating trading desk, insuring them againstData & Technology: gathering all the data necessary losses in the event of a counterparty default. Housingto calculate CvA and capital reserves translates into counterparty risk in one place allows senior managementa very challenging technology agenda. Most banks to get a consolidated picture of the exposures andhave multiple systems for reference data, market data, proactively address risk concentrations and other issues.and transactions. These systems may be further sub- As banks continue to ramp up active managementdivided into front-office analytical tools and back-office of CvA, having a specialised group allows carefulbooking systems, each with its own repository of market management of complex risks arising from liquidity,and reference data. The counterparty risk system must correlation and analytical limitations.integrate with potentially many of these systems in orderto extract the data needed to produce a comprehensive Decentralised infrastructures may make the data andset of counterparty risk metrics. technology challenges too great to ensure provision of meaningful consolidated counterparty risk metrics onFor a large bank, the counterparty risk system may price a timely basis. Some banks have aligned counterpartysomething on the order of one million transactions over risk management by business line in order to moreone thousand scenarios and one hundred time steps, or effectively manage the data and analytical issues at the100 billion valuations. If the bank actively hedges CvA, expense of certain benefits, like netting. For centralisedthe number of valuations is roughly multiplied that by the CvA desks, there is also the challenge of internal pricingnumber of sensitivities required. The counterparty risk and P&L policies. Most banks position CvA desks assystem’s infrastructure must also support back-testing, utility functions that simply attempt to recover hedgingstress testing and historical vaR. In addition to fine-tuning costs in CvA pricing.the analytics, acceptable levels of performance andscalability can be achieved by distributing computations Recent regulatory activity has also had a profound impactacross servers and processor cores using grid technology. on counterparty risk management. Mandating central clearing for an expanding scope of derivative productsWith the huge amount of data involved and analytical effectively moves counterparty risk out of complex CvAcomplexity, the ability to view the various counterparty and economic capital models and into more deterministicrisk metrics across a variety of dimensions is absolutely and transparent margining formulas. The heavilyessential. At the very least, the system should show collateralised inter-dealer market is also undergoingcurrent and projected exposures, CvA and regulatory significant changes. Institutions are now looking morecapital by counterparty, industry and region. The ability closely at optimising collateral funding through cheapest-to inspect reference, market and transaction data inputs to-deliver collateral, re-couponing existing trades tois vital in verifying calculated results and tracking down release collateral, and moving positions to centralerrors. The system must also provide reports for back- counterparties in order to access valuation discrepanciestesting, stress testing and vaR outputs with similar or more favorable collateral terms.aggregation and drill-down capabilities. It is expected that most corporate derivatives transactionsTrends: Post crisis, the ability for senior management will remain exempt from clearing mandates sinceto get a comprehensive view of the bank’s counterparty banks provide valuable hedging services in the formrisks is a critical priority. Consolidated risk reporting of derivative lines. The cost of extending these lines ishas been elusive due to front-office driven business increasing due to significantly higher regulatory capitalmodels. As influential revenue producers, trading desks requirements. Therefore, competitive CvA pricing andhave maintained a tight grip on data ownership, model economic capital optimisation will remain priorities fordevelopment and front-office technology. This has corporate counterparty risk management alongsideresulted in a proliferation of systems, making the job collateral and clearing processes. | 05
  6. 6. feATURe by ROHAN DOUGLAS, CeO of Quantifi and PeTeR DeCReM, Director of Rates at QuantifiOIS and CSA DiscountingFollowing the credit crisis, interest rate flows that are risk free or based on funding cost. Thismodelling has undergone nothing short approach is referred to as dual curve, OIS discounting, or CSA discounting and forces a re-derivation ofof a revolution. During the credit crisis, derivatives valuation from first principles. In addition,credit and liquidity issues drove apart the counterparty credit risk of (uncollateralised) OTCpreviously closely related rates. For transactions is measured as a CvA.example, Euribor basis swap spreadsdramatically increased and the spreads Impact of the Credit Crisis onbetween Euribor and Eonia OIS swaps the Rates Marketdiverged. In addition, the effect of As the credit crisis unfolded, there were significantcounterparty credit on valuation and risk impacts on the structure and dynamics of the ratesmanagement dramatically increased. market. Credit and liquidity drove segmentation andExisting modelling and infrastructure no rates that were previously closely related diverged, causing a rethink of how these rates should be modelled.longer worked and a rethink from firstprinciples has taken place. Reflecting the different credit risk and market segmentation between different Euribor rate tenors,Today a new interest rate modelling framework is basis swap spreads blew out during the crisis from beingevolving based on OIS discounting and integrated credit fractions of a basis point (where they had been quotedvaluation adjustment (CvA). Pricing a single currency for decades) to double digits in a matter of months. Theinterest rate swap now takes into account the difference 3M vs 6M Euribor Basis swap spread went from under abetween projected rates such as Euribor that include basis point to peak at over 44bp around October 2008,credit risk and the rates appropriate for discounting cash after the Lehman default. This divergence is again a06 |
  7. 7. reflection of different credit and liquidity risks between The larger banks have led the evolution of valuingthese indices. The longer term deposits (6M) carry more and managing counterparty credit risk. Over time theycredit risk than the shorter (3M) deposits. have converged to generally consistent methods and processes. The concept of a CvA is now widely accepted and consistently calculated across the markets. OTCThe New Interest Rate transactions that carry counterparty exposure executed byModelling Paradigm all the larger institutions now have a CvA component asClearly the credit crisis had a significant impact part of the valuation.on the interest rates market. These changes havedriven a profound shift in the way all OTC products Dual Curve OIS Discountingare valued and risk managed. The result has beenan abandonment of the classic derivatives pricing Curve Constructionframework based on single interest rate curves and Following the credit crisis, interest rate derivativesthe introduction of a new approach that takes into are now valued with models that reflect the observedaccount current interest rate dynamics and market market segmentation, counterparty risk, and interestsegmentation using multiple curves. rate dynamics. valuing a single currency vanilla interest rate swap involves calculating forward rates basedDual Curve/OIS Discounting: on Euribor rate curves and discounting expectedThe old-style no-arbitrage, single-curve derivatives cash flows using Eonia rates. As in the single-curvevaluation framework where Euribor was a reasonable case, these curves are calibrated from liquid interestproxy for a risk-neutral discount rate has been rate products. For the EUR curves this includespermanently changed by the credit crisis. An money market securities, futures, FRAs, Eonia swaps,understanding of the credit risk embedded in Euribor basis swaps and interest rate swaps. The process isand similar rates and an increased importance in complicated, however, by changes to the modellingthe modelling of funding have driven a separation principles around calculating the expected forwardbetween the index rates used for the floating legs of rates. These forward rates must be conditional on thethe swap (the projection rates) and the appropriate Eonia rates used for discounting.rates used for present value (the discount rates). Themarket-standard rate to discount future cash flows isnow OIS rates. “A new generation ofThe method of projecting rates using Euribor interest rate modelling isand discounting rates using Eonia changes the evolving. An approach basedfundamental framework for existing derivativemodelling. It has required a rethink from first principles on dual curve pricing andthat continues to be discussed and refined. Pricing integrated CVA has becomeand risk managing even a vanilla single currency the market consensus.”swap has become significantly more complex. Curveconstruction, pricing and hedging now involvemultiple instruments and additional basis risks. These A new generation of interest rate modelling iscomplexities compound for interest rate products such evolving. An approach based on dual curve pricingas cross currency swaps, caps/floors and swaptions. and integrated CvA has become the market consensus. There is compelling evidence that theCounterparty Risk and CvA: market for interest rate products has moved to pricingThe measurement and management of counterparty on this basis, but not all market participants are atrisk is now something that impacts all market the stage were existing legacy valuation and riskparticipants. Accurate valuation of OTC products now management systems are up to date. The changesrequires accurate valuation of the credit component required for existing systems are significant andof each transaction. In addition, regulatory initiatives present many challenges in an environment wheresuch as Basel III and Solvency II, along with accounting efficient use of capital at the business line level isrules such as ASC 820 (FAS 157) and IAS 39 have becoming increasingly important.mandated more accurate counterparty risk valuationand risk management. | 07
  8. 8. Whitepapers QX.1 Preview QX.1 is Quantifi’s next major release onOIS AND CSA DISCOUNTING schedule for this quarter. QX.1 will include significant enhancements across all of Quantifi’s• A new generation product range and continues our tradition of of interest rate first to market releases that address our clients’ modelling based on needs. A sample of new features include: dual curve pricing and WHITE PAPER integrated CVA OIS AND CSA DISCOUNTING • expanded asset coverage and product is evolving enhancements for fX options and exotics, basis swaps, callable bonds, Co-Authored by Rohan Douglas and Peter Decrem (Quantifi) • A new generation of interest rate modelling based on dual curve pricing and integrated CVA is evolving • This new framework requires a rethink of derivative modelling from first principles and presents significant convertible bonds, fRAs, swaptions challenges for existing valuation, risk management, and margining systemsCHALLeNGeS IN and credit index options www.quantifisolutions.comIMPLeMeNTING • Significant enhancements to counterpartyA COUNTeRPARTy RISK risk management including Basel III compliantMANAGeMeNT capital calculations, historical CVA VaR, stress testing, back-testing, enhancements toPROCeSS margin period of risk calculations, collateral thresholds by rating, additional calibration• Key data and technology challenges tools and extended product coverage for• Current trends in best practices commodities and inflation • expanded data management capabilitieseVOLUTION Of to simplify complex data integration and data managementCOUNTeRPARTy CReDIT RISK • A new generation of APIs for plug-and-• explores practical implementation issues and play client model integration, product how approaches have converged extendibility, and data integration• An insider’s view from the major banks that have influenced this market • A redesigned reporting engine with in- memory hypercube for improved reporting and drill down flexibility, simplified integrationRequest a copy: of external data sources, and performance for high-volume portfoliosABOUT QUANTIfIQuantifi is a leading provider of analytics, trading and risk management software for the Global Capital Markets. Our suiteof integrated pre and post-trade solutions allow market participants to better value, trade and risk manage their exposuresand respond more effectively to changing market conditions.founded in 2002, Quantifi is trusted by the world’s most sophisticated financial institutions including five of the six largestglobal banks, two of the three largest asset managers, leading hedge funds, insurance companies, pension funds and otherfinancial institutions across 15 countries.Renowned for our client focus, depth of experience and commitment to innovation, Quantifi is consistently first-to-marketwith intuitive, award-winning | www.quantifisolutions.comeurope: +44 (0) 20 7397 8788 • North America: +1 (212) 784 6815 • Asia Pacific: +61 (02) 9221 0133follow us on:© Quantifi Inc. All rights reserved. Quantifi, Quantifi Risk, Quantifi XL, Quantifi Counterparty Risk, Quantifi CvA are trademarks of Quantifi Inc.