Firms seeking to proactively manage counterparty risk and meet Basel II requirements in today’s market need a system that measures not just current exposure (CE), but also potential future exposure (PFE) and credit valuation adjustment (CVA), particularly when dealing with complex OTC instruments.
To meet this need, Numerix Counterparty Risk leverages Numerix’s award-winning analytics and CompatibL’s data-management expertise, giving users the ability to actively limit exposure across business units and instrument types with accurate PFE and CVA calculations using an accelerated Monte Carlo simulation engine.
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Key Features
- Calculate PFE and CVA using Numerix Monte Carlo, including deal price, deal aging, collateral posting and netting agreements
- Identify potential large exposures and correlations using stress tests and drill-down reports based on business unit, instrument type, desk, position, maturity bucket or other factors
- Easily integrate new trade types and products, including complex or illiquid instruments that often account for the greatest amount of credit risk in a portfolio
- Analyze the incremental impact of new trades on potential exposure
- Accurately hedge credit risk in CVA calculations by using consistent calibration for both deal-pricing and market-evolution models
- Import trade, market and reference data from multiple trading and risk systems
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Manage exposure with PFE and CVA calculations, shown here at various intervals of confidence
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The Numerix Solution to Modeling Potential Exposure
Given the inherent challenges in accurately modeling potential exposure, some firms limit risk calculations to simpler methods based solely on current exposure and notional. This approach is easier to quantify, but it also has built-in flaws that can prove to be critical — particularly during periods of market stress.
For example, such simplified methods tend to break down during the periods of high volatility, providing estimates for PFE and CVA that that may be substantially different than the true measures. They are also not effective for pre-trade analysis, as many OTC instruments start out on the date of inception with little or no exposure and ramp up over time. And for portfolios containing complex deals, simplified methods may significantly overestimate Basel II capital requirements.
In contrast, Numerix Counterparty Risk, powered by CompatibL, uses high-performance Monte Carlo simulations to converge on an accurate estimation of PFE and CVA at various levels of confidence across multiple trade types and counterparties. With this image of the future in hand, it’s possible to exert far-greater control over exposure: incorporating the cost of credit risk (CVA) into new trades, restricting trading based on risk limits, and reducing the reliance on collateral to mitigate credit risk.
Simulation Methodology
Numerix Counterparty Risk, powered by CompatibL, aggregates several algorithms to generate a deal price for each path and timestep:
Pricing Model
Determines how deal prices are calculated in the simulation: fast analytical models can be used for linear and vanilla deals, while complex deals require a term-structure model.
Market Evolution Model
Generates simulation paths and derived market data. By using the same calibration as the pricing model, calculated CVA is consistent with the price of the instrument's embedded credit risk.
Counterparty Default Model
Defines how default events are simulated, using either a "default/no-default" assumption or a rating-transition model.
Deal Aging Model
Calculates exposure for complex instruments with embedded options that, if exercised, can significantly alter the risk profile. For example, a deal may include an option that may be exercised if the prevailing interest rate rises above a certain level. The model incorporates this potential change into exposure calculations by simulating the market data associated with the exercise event.
Cashflow Reinvestment Model
Simulates how cashflows from the deal are reinvested, including into other instruments bearing counterparty exposure.
Risk Analysis and Reporting
The application integrates the simulation's raw output with additional user-defined factors to generate the final PFE and CVA data.
- Netting Agreements: Defines how credit exposures from multiple deals with the same legal entity are offset against each other
- Collateral Posting: Specifies the treatment of collateral, including threshold and posting delay, enabling PFE calculations on a collateralized or uncollateralized basis.
- Counterparty Default Assumptions: Describes the relationship between default events and the counterparty's exposure (either uncorrelated or "wrong-way" correlated)