As derivatives experts have debated XVA pricing and risk adjustments over the past several years, today the industry seems to have reached a consensus at least in terms of how these calculations should be derived from a quantitative perspective.
In this Q&A Dennis Sadak, Vice President of the Numerix Client Solutions Group, discusses how the industry has moved from debating methodologies to putting XVA into practice. He examines the real-world application of these calculations and provides examples of how they are being implemented in today’s front-office trading environment.
Q: How are these calculations being incorporated into the front office? And how are they impacting trading decisions?
A: That fact of the matter is that these valuation adjustments are now being reflected on banks’ balances sheets, and as a result are affecting the bottom line. Consequently, banks have to manage this P&L and that’s responsibility of the front office. We’ve actually seen specific desks popping up that are dedicated to managing these valuations charges, namely CVA desks.
In terms of more market risk calculations, when we started the XVA discussion it revolved around managing counterparty credit risk, looking at CVA and DVA. Now, we’ve seeing XVA evolve to include a broader set of market risk components as well as new requirements for real-time. Essentially the front office has had to evolve with these changes and apply new technologies to keep pace with innovation and that means assessing market and credit risk in a holistic manner.
Q: How is this changing the front office’s view of the risk they are taking on?
A: Now that CVA is actively being managed, we have to understand what sensitivities are tied to this valuation adjustment as well as others. As a result we need to be able to calculate the greeks, which are part of market risk. Now traders are starting to look at what are the different risk factors that impact valuations adjustments including CVA, DVA, FVA and others. Furthermore, corporations themselves want to understand the total cost of doing business.
Q: As we discuss the importance of cost, how are these measures being utilized to identify opportunities in the market?
A: The opportunity lies with being able to capture the entire cost of trading. In other words we want to be able to calculate the profitably of each trade, and determine how each of those trades impacts the bottom line of the corporation through their lifetime. This is where the full range of adjustments come in, also known as TVA (Total Valuation Adjustment).
In terms of real-time, calculating these adjustments is very computationally intensive. So instead of constantly recalculating, these measures can be looked at on an incremental basis by looking at the incremental charges.
So before putting on a trade a trader could actually take a look and see their concurrent CVA charge given their portfolio now, and what could happen if they add a trade or close out a trade. These calculations could indeed be done in real-time, and the impact of these changes can be captured and analyzed in real-time. The ability to do this type of real-time pre-trade analysis is an extremely powerful capability for the front office.
