Feb 21, 2012

CVA changes everything we know about derivatives valuation

Denny Yu, VP Risk at NumerixNumerix presents “Stress Testing and Hedging CVA” at PRMIA


 

With Credit Valuation Adjustment (CVA) on the forefront of everybody’s minds, last week Numerix participated at the Professional Risk Managers’ International Association (PRMIA) Montreal CVA event, hosted by Ernst and Young.  Denny Yu, Product Manager of Risk at Numerix, spoke at this event and shared some key insights regarding “Stress Testing and Hedging of CVA Risk.” Below are highlights from the CVA event discussion:

CVA Impact on the Trading Desk

It is important to recognize that CVA is not about the counterparty default; it is about the sensitivity of derivative exposures to credit spread, explained Denny Yu. In relation to this, other points to consider include the observation that: Dealer default happens very rarely; Buy side counterparty default happens once in awhile; and credit spread goes up and down every day, increasing your P & L volatility and masking the true performance of your OTC trading business. CVA is not like traditional issuer risk that can be dealt with at the level of individual bond position. Issuer risk involves simpler valuation; hedging and stress testing.

CVA cannot be valued or hedged easily, and also requires knowledge of Credit Support Annex (CSA) details. An accurate CVA calculation depends on the entire portfolio of trades between your firm and the counterparty being looked at holistically, Mr. Yu explained, adding that it also depends on the nature of collateral posted or received by the counterparty.

Other important points to consider about CVA include:

A)     What does CVA change for the business?

 Example 1

  • Imagine you are running a flow desk
  • You are fully hedged to your market risk today
  • The next day you suddenly have negative P&L of $50m
  • How did this happen?
  • Is this P&L swing because your counterparty reported weak earnings numbers and their credit spread widened (but why is this your problem?)
  • OR because your firm reported strong earnings numbers and its credit spread has narrowed, reducing the DVA?

Example 2

  • You are running a derivatives desk
  • If you were not explicitly trading credit before, now you are - and you do not have credit traders
  • Credit exposure cannot be hedged for the majority of counterparties – increasing the volatility of your P&L
  • Your counterparties want to charge you for CVA, but do not want you to charge them for their DVA – and arguing about the adjustment requires a full tally of mutual OTC positions across all desks in both firms

 B)       What does CVA change for the quants?

  • CVA changes everything we know about derivatives valuation
  • No such thing as fair value – deal value depends on the counterparty
  • No such thing as mark-to-market at deal level – depends on the rest of the portfolio
  • Invalidates essential assumptions behind risk neutral valuation – market completeness and hedge availability to create a riskless portfolio

 

 Hedging CVA

The key objectives of hedging CVA are: 1) reducing the sensitivity and 2) reducing the exposure. Reducing the sensitivity involves avoiding CVA-driven P & L when the credit spread of the counterparty or your firm changes and also involves protecting your CVA position for the duration of your trades with the counterparty. Reducing the maximum PFE at a given confidence level (e.g. 95%) achieves the second objective above. However, these two goals are conflicting and are difficult to achieve at the same time, so they need to be balanced properly.

 

Vanilla swap value over time

A Closer Look at Problems with Static CDS Hedging

There are certain problems found with static CDS hedging. These problems can be resolved by dynamic hedging and by adjusting CVA position over time, and depending on the amount of exposure you have today:

  • CDS will pay out the same amount if counterparty defaults, independently of the amount of your exposure
  • CDS will pay out every time, while you will have positive exposure only some of the time

 

Stress Testing CVA and Wrong Way Risk

The traditional stress testing approach for CVA is no different from stress testing a regular portfolio of OTC transactions. Sensitivity can be with respect to: Credit spreads, Interest rates, FX rates and Equity prices.

 

Examples:

Sensitivity to credit spread

 

Sensitivity to market rates and vols

Stress testing wrong way risk is more complex from traditional stress testing because of the complex nature of correlation between market factors and credit spreads. For instance, in 2008, it became very clear that the traditional quant theory did not do a good job modeling credit correlation.

 

Key Takeaways to Consider about your Firm’s CVA:

  • CVA impacts the trading desk
  • Either every desk is a credit desk, or the firm needs a central CVA desk
  • CVA impacts quant research
  • Changes the most fundamental assumptions in OTC derivatives risk-neutral pricing
  • CVA changes hedging and stress testing
  • It is not about the default
  • Need to hedge risks you did not know you had

To learn more about Stress Testing and Hedging CVA, please contact sales@numerix.com.

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