XVA. Green Andrew
to be held in a similar way to the way that CCP initial margin requirements operate.
CCP Pricing
• Risk-neutral valuation: CCP methodology including CCP discount curves
• Hedging/Management costs
• Residual CVA (including impact of variation margin)
• Residual FVA (including impact of variation margin)
• COLVA/Collateral effects
• KVA
• Initial margin
• Liquidity buffers
• Default fund
• Profit.
For trades cleared through a CCP the components of a price include similar components to those of a trade supported by a CSA agreement. Residual exposure above the collateral provided as variation margin gives rise to CVA and FVA as with CSA pricing. Hedging and trading management costs are the same as is the addition of a profit margin. The lifetime cost of capital is also present although the risk-weight applied to qualifying CCPs is the relatively low value of 2 % (BCBS, 2012c). As with CSA pricing a COLVA adjustment may be needed. In addition to variation margin, three other payments are often made to CCPS: initial margin, liquidity buffers and default fund contributions. The initial margin is designed to cover exposure that might arise due to market movements during a close-out period and hence prevent loss should a counterparty subsequently default. Liquidity buffers can also be applied if the risk position of a CCP member is large. All CCP clearing members are required to post default fund contributions which are designed to be used in the event of the default of a CCP member.
1.3.2 Risk-Neutral Valuation
In all three of the cases studied in section 1.3.1 a baseline risk-neutral valuation model is still used. The risk-neutral valuation is the value as seen by the derivative trader and is the value this trader is tasked with hedging. Normally this trader will be an asset-class specialist with experience of hedging in the markets underlying the derivative and so this is where the majority of the market risk on the trade is managed. The risk-neutral trade level valuation makes the usual assumptions of no credit or funding risk so in effect this valuation assumes that a perfect CSA agreement is in place. However, in general the choice of discounting curve varies depending on the arrangements under which the derivative has been traded.
Unsecured
The choice of discount curve is still a matter of debate in the industry and depends on internal factors. Many banks have left the baseline valuation of unsecured trades using xIBOR-based discounting models (Solum Financial Partners, 2014). In many cases this will be exactly the same multi-currency discounting model that was prevalent before the credit crisis, typically where all other currencies had cross-currency basis quoted against the US dollar interest rates. Other choices are also possible including OIS discounting. The choice may be made to use a single currency discount curve for all unsecured trades, say for example Fed Funds. A further alternative might be to allow single currency derivatives to be discounted using the appropriate OIS curve for that currency and treat multi-currency trades differently. This has the advantage that single currency trading books would not be exposed to any cross-currency effects. If the bank elects to use funding discounting models for unsecured trades, then the discount rate will be the bank’s internal cost of funds curve. The possible choices and motivating factors are listed in Table 1.2.
Table 1.2 The possible choices of discounting for the baseline risk-neutral valuation of unsecured derivative trades.
The choice of discounting depends on three key factors: organisational design, internal bank modelling of funding costs and the expected reference close-out in the event of default. Note that this reflects the practical reality of what happens in banks rather than theoretical correctness of any models used.
Organisation design
Organisational design4 determines which trading desks manage which risks. Broadly there are two main choices; either each individual trading desk manages their own funding (distributed model) or there is a central management desk for funding (centralised model). In the distributed model each trading desk will need to know the funding impact of all unsecured trades on their book. This would most likely be done using a funding discounting approach, although other models could be used. In the centralised model the asset-class trading desks will either wish to measure the funding risk and lay it off with the central desk or not be exposed to it at all. If the asset-class desks hedge out funding risks with the central desk then they will measure the funding cost and hedge it out through funding basis swaps, otherwise the asset-class desk would value all their unsecured trades either at xIBOR or OIS and be oblivious to funding considerations, with the central funding desk calculating and managing FVA directly.
Bank models of funding costs
The bank model of funding costs also plays a role in determining the choice of discounting for unsecured trades. As will be discussed at length in Chapter 9 there are broadly two types of model for FVA, discounting approaches and exposure-based approaches. Discounting approaches simply adjust the discount curve, while exposure-based approaches use models similar to those used for CVA. Discounting-based approaches simply adjust the risk-neutral valuation by using the cost of funds as the discount rate and hence the risk-neutral valuation. Exposure-based approaches apply FVA as an adjustment to the portfolio valuation in the same way as CVA so the underlying risk-neutral valuation remains unchanged.
Reference close-out
The reference close-out value is the final factor in determining the choice of unsecured discounting model. To be consistent with the CVA model the unsecured reference valuation should match that used in the CVA model so that in the event of default the risk-neutral valuation matches the claim value made against the administrators of the defaulted counterparty and the CVA becomes the realised loss on the trade once the actual recovery rate is known. Note that the use of funding discounting models implies that the CVA model has to be changed to be consistent with this choice of FVA model.5
CSA
CSA and OIS discounting will be discussed in detail in Chapter 8; however, it should be noted here that the implications of Piterbarg (2010) and Piterbarg (2012) are that the appropriate discount rate for fully collateralised counterparties is the rate of interest received on the posted collateral. Hence the discount curve depends on the terms of the CSA agreement. In the simplest case where collateral can only be posted in cash in a single currency then the rate of interest received on posted collateral is normally the overnight rate in that currency. Hence the appropriate discount curve is the OIS curve in the same currency as this curve represents the market expected overnight rate extended out to longer maturities. In the case where cash in multiple currencies can be posted the appropriate discount curve is a blended curve which represents the rate earned on the cheapest-to-deliver currency.6 Many CSAs allow a variety of securities to be posted as collateral and in this case the choice of appropriate discount curve becomes more complex.
CCP
The discount curve used by CCPs to determine the value for the purposes of margin calls is determined by the internal models of the CCP. For single currency interest rate swaps cleared through LCH.Clearnet SwapClear this is currently a single currency OIS discounting methodology, having switched over from a LIBOR methodology during 2010 (LCH, 2010a). This can be viewed as the risk-neutral valuation of the interest rate swap, but there is no guarantee that a clearing member’s own risk-neutral valuation will match that of SwapClear and this could become problematic because of the privileged position held by CCPs (Kenyon and Green, 2013c).
1.3.3 Hedging and Management Costs
The bid-offer spread quoted by trading desks has always been included in prices and reflects the trading
See Chapter 8.
Chapter 8 discusses the construction of OIS discounting curves in more detail. It should be noted that collateral substitution where one piece of collateral is exchanged for another depends on the local legal framework and that collateral can be viewed as “sticky” in some jurisdictions. The pricing of the embedded cheapest-to-deliver option is not straightforward, therefore.