Numerix 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
Example 2
B) What does CVA change for the quants?
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:
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:
To learn more about Stress Testing and Hedging CVA, please contact sales@numerix.com.