The xVA Challenge. Gregory Jon

KVA. On the other hand, reducing KVA may lead to greater CVA volatility (Section 18.3.8).

      The above explains why it is critical to manage xVA centrally and make consistent decisions regarding pricing, valuation and risk mitigation so as to optimise aspects such as capital utilisation and achieve the maximum overall economic benefit.

4.1.4 Exposure and product type

The split of OTC derivatives by product type is shown in Figure 4.2. Interest rate products contribute the majority of the outstanding notional but this gives a somewhat misleading view of the importance of other asset classes, especially foreign exchange and credit default swaps. Whilst most foreign exchange products are short-dated, the long-dated nature and exchange of notional in cross-currency swaps means they have considerable counterparty risk. Credit default swaps not only have a large volatility component but also constitute significant “wrong-way risk” (discussed in detail in Chapter 17)

Figure 4.2 Split of OTC gross outstanding notional by product type as of June 2014.

The above can be seen when looking at the averaged response from banks on their CVA breakdown by asset class in Figure 4.3. Although interest rate products make up a significant proportion of the counterparty risk in the market (and indeed are most commonly used in practical examples), one must not underestimate the important (and sometimes more subtle) contributions from other products. It is also important to note that, while large global banks have exposure to all asset classes, smaller banks may have a more limited exposure (for example, mainly interest rate and FX products). End-users may also have limited exposure: for example, a corporate may use only interest rate and cross-currency swaps.

Figure 4.3 Split of CVA by asset class (average over all respondents).

Table 4.1 Comparison of the total notional outstanding and the market value of derivatives ($ trillions) for different asset classes as of December 2014.

      * This is calculated as the sum of the absolute value of gross positive and gross negative market values, corrected for double counting.

      Source: BIS.

A key aspect of derivatives products is that their exposure is substantially smaller than that of an equivalent loan or bond. Consider an interest rate swap as an example; this contract involves the exchange of floating against fixed coupons, and has no principal risk because only cashflows are exchanged. Furthermore, even the coupons are not fully at risk because, at coupon dates, only the difference in fixed and floating coupons or net payment will be exchanged. Comparing the actual total market of derivatives against the total notional amount outstanding therefore shows a significant reduction, as illustrated in Table 4.1. For example, the total market value of interest rate contracts is only 3.1 % of the total notional outstanding. It is the market value that is more relevant, since this is representative of the loss that is suffered in a default scenario and is the amount that has to be funded or collateralised.

4.1.5 Setups

Broadly speaking, there are two situations in which counterparty risk and related aspects such as funding, collateral and capital arise. The most obvious (Figure 4.4) would apply to an end-user using OTC derivatives for hedging purposes. Their overall portfolio will be typically directional (but not completely so, as mentioned below), since the general aim will be to offset economic exposures elsewhere. The result of this will be that MTM volatility will be significant and any associated collateral flows may vary substantially. Indeed, the fact that substantial collateral may be required over a short time horizon is one reason why many end-users do not enter into collateral agreements. Another implication of directional portfolios is that there may be less netting benefit available. In practice, an end-user will trade with a reasonable number of bank counterparties depending on the volume of their business and risk appetite.

Figure 4.4 Illustration of the classic end-user counterparty risk setup.

Figure 4.5 Illustration of the classic bank setup.

      Another important feature is that end-users may hedge risks on a one-for-one basis; for example, the terms of a swap may be linked directly to those of bonds issued rather than the interest rate exposure being hedged more generically on a macro basis. End-users may find it problematic when unwinding transactions, since the original counterparty will not necessarily quote favourable terms. Furthermore, if they do execute offsetting transactions – for example, a supranational may execute receiver swaps to hedge their lending whilst also having payer swaps to hedge borrowing – the terms received will be less favourable than if they macro-hedged the overall risk. This is a consequence of hedging borrowing and lending on a one-to-one basis. For a similar reason, default situations will be problematic because an end-user may want to replace transactions on a one-for-one basis rather than macro-hedging their exposure to the defaulted counterparty. This will likely be more expensive and time-consuming.

For a bank, the classic counterparty risk situation is rather different (Figure 4.5). Banks will typically aim to run a relatively flat (i.e. hedged) book from a market risk perspective. This means that a transaction with a client will be hedged (either on a macro basis or one-for-one) with another market participant. This is likely to lead to a series of hedges through the interbank market, ending with another opposite exposure to another end-user. In this situation, the bank may have little or no MTM volatility or market risk. However, they do have counterparty risk to both counterparties A and B, because if either were to default it would leave market risk with respect to the other side of the trade.

      Another important feature of this situation is that client transactions will often be uncollateralised, whereas the hedges will be collateralised (or centrally cleared). The counterparty risk problem exists mainly on the uncollateralised transactions (although there is still material risk on the hedges). Whilst the overall MTM is neutralised, this introduces an asymmetry in collateral flows that can be problematic. Dealers also suffer from the directional hedging needs of clients. For example, they may transact mainly receiver interest rate swaps with corporate clients. In a falling interest rate environment, the bank’s exposure will increase substantially and the hedges of these swaps will require significant collateral posting. Figure 4.5 is very important as a starting point for many different types of analysis and will be referred back to at several later points in this book.

      4.2 Components

      Counterparty risk represents a combination of market risk, which defines the exposure and credit risk that defines the counterparty credit quality. A counterparty with a large default probability and a small exposure may be considered preferable to one with a larger exposure and smaller underlying default probability – but this is not clear. CVA puts a value on counterparty risk and is one way to distinguish numerically between the aforementioned cases. CVA will be discussed in detail later, but we now define the important components that define counterparty risk and related metrics.

4.2.1 Mark-to-market and replacement cost

      Mark-to-market (MTM) is the starting point for analysis of counterparty risk and related aspects. Current MTM does not constitute an immediate liability by one party to the other, but rather is the present value of all the payments that a party is expecting to receive, less those it is obliged to make. These payments may be scheduled to occur many years in the future and may have values that are strongly dependent on market variables. MTM will be positive or negative, depending on the magnitude of remaining payments and current market rates.

      The MTM with respect to a particular