XVA. Green Andrew
of the current mark-to-market of the counterparties' derivative portfolio. However, LCH.Clearnet Swapclear specifies the initial margin as a dynamic quantity with its PAIRS methodology (LCH, 2012e) using a historical Value-at-Risk measurement. Significant intraday market moves can trigger margin calls for additional initial margin (LCH, 2012b). For positions with large net risk, LCH.Clearnet SwapClear specifies a series of liquidity multipliers to increase the margin position to reflect the limits of market liquidity should the position be required to be closed out completely (LCH, 2010b). Finally a default fund has been created from contributions from all large clearing members to allow the clearing house to survive one or more defaults by clearing members (LCH, 2012a).
Only standardised OTC derivative contracts can be cleared through CCPs. In response to a desire that all transactions between significant financial institutions be margined, the Basel Committee on Banking Supervision has issued a consultation document that will enforce similar rules on OTC derivatives traded between financial institutions (BCBS, 2012h). Most of these contracts are currently traded under CSA agreements and hence are already subject to collateral support. However, the proposal will add the requirement for both counterparties to post initial margin, although there will be no additional posting requirements such as for CCP default funds.
2.4.4 Capital
Collateral can be viewed as a means of ensuring that the defaulter pays in the event of a default. Capital, in contrast, is a way of holding sufficient reserves to enable the non-defaulting entity to manage the loss arising from the default. Capital therefore is a mechanism in which the non-defaulting party ‘pays’ for the default. Regulatory capital is the amount of capital that a financial institution must hold in order to satisfy its regulator. The Basel Accords are a series of regulatory frameworks that provide a methodology for calculating the amount of capital required to support banking businesses that have been proposed by the international body the Basel Committee on Banking Supervision within the Bank for International Settlements (BCBS, 2012a). There have been four major developments of the regulatory capital framework, known as Basel I introduced in 1988, Basel II introduced in 2006, Basel II.5 introduced in the immediate aftermath of the 2008 financial crisis and Basel III introduced in 2010 for implementation on 1 January 2013 (BCBS, 2012d). Implementation of the Basel framework is at varying stages globally with the European Union being one of the most advanced through Capital Requirements Directive 4 or CRDIV. The impact of capital on pricing derivatives is discussed in Chapter 12.
2.4.5 Break Clauses
Many OTC derivative contracts contain one or more break clauses that provide for the early termination of a derivative contract. There are two types of break clause, mandatory and optional. A mandatory break clause terminates the trade prior to the natural maturity date, with the remaining value of the derivative settled by a cash payment. So, for example, a twenty-year interest rate swap with a mandatory break clause after five years will terminate five years after the start of the transaction with the mark-to-market value of the remaining fifteen years of the transaction paid in cash on the appropriate settlement date immediately after the mandatory break date. Ignoring credit risk, funding costs and capital considerations, the value of the two trades with and without the break clause will be the same. However, the expected exposure of the trade with a mandatory break is terminated after five years and hence the credit risk and CVA are much lower. In practice, trades with mandatory break clauses reduce the initial cost of the derivative for the counterparty and the trades are often restructured just prior to the break date. Figure 2.4 illustrates a swap with a break clause half way through the underlying term.
Figure 2.4 A swap with and without a break clause and the associated expected positive exposure profile. For the swap with the break clause, the CVA is lower.
Optional break clauses give the option to one or both counterparties to terminate the derivative on one or more dates prior to the natural maturity of the trade. Settlement then proceeds in the same way as a mandatory break clause, with a cash settlement of the mark-to-market of the remaining trade. In practice, optional break clauses have been rarely, if ever, exercised irrespective of any considerations of optimal exercise. The argument has been that exercising the break clause would ruin the relationship with the client. Internally within banks the right to exercise the credit break has often sat with client relationship management who have had few incentives to use the breaks.20 However, many derivative dealers are now arguing that optional break clauses should now be exercised and actively used as a credit mitigant (Cameron, 2012).
2.4.6 Buying Protection
The idea of buying “insurance” or “protection” against counterparty default is quite an old one. Bond insurance or financial guaranty insurance was introduced by American Municipal Bond Assurance Corp or AMBAC in 1971 (Milwaukee Sentinal, 1971). Municipal bond insurance is a type of insurance in which the bond insurer guarantees the interest and principal payments on a municipal bond. A number of bond insurance companies were created and they became known as monolines as they did not have other lines of insurance business. Bond insurance was a generally successful business but after the development of structured credit derivative products many bond insurers entered the credit derivatives market leading to significant losses. Ambac filed for protection from creditors under chapter 11 on 8 November 2010 (Ambac, 2010).
Credit default swaps offer the main means by which credit protection can be bought and sold, and as such are the primary mechanism for CVA trading desks to hedge out credit risks. Physically settled single name CDS contracts pay out the notional amount in exchange for a defaulted bond, although cash settled variants that pay
on default are also available. Hence, single name CDS provide a means of directly protecting a notional amount against the default of a specific counterparty. There are some complications in that the CDS is triggered by a number of specific default conditions and that some, like voluntary restructuring, are typically excluded. This means that the CDS does not always pay out when losses are taken. The Greek sovereign restructuring provides an example of this where the initial voluntary debt exchange did not trigger the sovereign CDS, only the later use of a ‘collective action clause’ triggered the CDS as it involved an element of coercion (Oakley, 2012).
CDS trade only a limited number of reference names and so in many cases buying single name CDS to hedge CVA is not possible. CDS indices such as the iTraxx and CDSIndex Company series can provide an alternative. These are liquidly traded indices which include a basket of underlying CDS contracts. They respond to changes in underlying perceptions of creditworthiness in the underlying basket of names and hence can be used to hedge general sensitivity to CDS spreads. Usually the members of a CDS index are also traded through the single name CDS market. CDS and CDS indices are discussed in Chapter 4 and active management of CVA in Chapter 22.
CHAPTER 3
CVA and DVA: Credit and Debit Valuation Adjustment Models
The only certainty is that nothing is certain.
3.1 Introduction
Recall the definition of CVA, given in equation (2.6). Re-arranging this formula gives
(3.2)
where in the second line I have introduced the notation,
This formula highlights