Mar 5, 2013

Economic Value Adjustment – The Intersection of CVA, FVA, OIS, & CSAs for OTC Derivatives

In this video blog, Numerix experts discuss the historical context and interconnectivity between OIS discounting, cheapest-to-deliver, funding valuations adjustments, CVA, DVA, and CSAs – and why the entire Economic Value Adjustment is now critical for both buy and sell-side market participants to take into consideration.

They explore the notion of risk in today’s market and regulatory environment. Though standardization implies simplicity, differing approaches to risk management and the valuation process are leading to increased complexity. They also discuss the primary risks both the buy and sell-side institutions are facing – and how they can best be managed through portfolio optimization and hedging.

Weigh in and continue the conversation on Twitter @nxanalytics, LinkedIn, or in the comments section below.

Jim Jockle (Host): Hi welcome to Numerix Video Blog, I’m your host Jim Jockle. With me today is Tom Davis, Ph. D. from the Numerix Client Solutions Group. Welcome Tom, how are you?

Tom Davis (Guest): Good, thanks. Thanks for having me Jim.

Jockle: So I want to take just half a second. We’ve been talking about webinars on our video blogs, on so many different topics but one thing that we really haven’t done yet is start to put it together and I really just want to talk in a high level in this video blog on when we think about things like OIS discounting, funding valuations adjustments, we threw CVA, DVA into the mix, we’ve been talking cheapest to deliver, we’ve been talking CSA’s and standardized CSA’s, for this audience, I think it’d be worth just taking a minute Tom, and give us the end to end connectivity on this. How does this all come together and why people should be really concerned?

Davis: So after 2008 we realized that we needed different projection curves for six month versus three month and different tenor, and there a number of drivers for this mostly credit risk, so the longer the tenor the more credit risk you have embedded in say the bank. Once we realized there was a multitude of curves to use for projection, the question really arose, what curve should we use for discounting then?

So this was the manner of thought and debate and we see the market now moving, say LCH is moving towards an OIS, overnight index swap curve for discounting, and the reason is, it’s collateral, it’s fundamentally the reason why it’s collateral because when you have to fund your collateral, which you’re posting daily now, how you fund that years ago on the overnight markets. That’s why we’re using the overnight to discount our cash flows. Now this really was the first time we realized that funding was crucial to the price of the actually derivatives, and so if we think about now all the different optionalities matures embedded into a CSA, or a credit support annex,  we see that there’s things like up threshold, down threshold, minimal margin amount, minimal transfer amount, all of these things should really be embedded into how we discount because that represents how we fund, so funding value adjustment is really looking at throughout the lifetime of your trade, the different ways the CSA impacts that valuation, what’s the most optimal collateral security or currency to post throughout the lifetime of the trade, you’ll see it’s actually a complex operation where you’ll need to understand the correlations between the market movements of your trade as well as the collateral that you could post.

The cheapest-to-deliver curve is really a snapshot of today of what could be the most optimal margin to post throughout the lifetime of a certain trade, however to really capture the funding value adjustment, you’ll need to do the whole complex calculation and simulate throughout the lifetime of the trade.

Jockle: So from an argument perspective, in terms of if you’re managing at your desk, to maximum profitability, whether buy-side or sell-side, it’s almost the entire economic value adjustment that has to be taken into consideration is that correct?

Davis: Precisely. The front office and the sell-side are always worried about profit and loss, P&L, and so this actually does impact that. If you put on a trade with a certain counterparty you can get a better CVA, but of course you could also in the lifetime of your trade net worse, so it’s really important for the front office to understand the entire portfolio perspective and entire bank perspective, and on the buy-side you really need to know when you’re trading the bilateral margin situation, is the margin call correct, am I over-margined, because you can actually reduce the efficiency of changing your risk profile with the trade, and of course on the buy-side where the core competency is providing wealth management, in terms of portfolios, what they need to do is make sure that the margin cost in their firm doesn’t actually over shadow the economic cost of the benefit of having that trade on their portfolio.

Jockle:  So let’s talk about risk, and maybe we can put it in buy-side and sell-side. Because as we move towards standardization, standardization implies simplicity, but what we’re experiencing is the exact opposite in terms of increased complexity, and there’s holistic approaches to take this from infrastructure risk management mindset and culture, or there’s more traditional siloed approaches in terms of charging back from different departments and different groups to have that economic impact, but the question that I’d like you to tackle Tom, is really around at a high level, what is the risk? Is it improper hedging, is it higher regulatory cost of capital, is it all of the above without taking into consideration this kind of complexity?

Davis: One of the biggest risks on the buy-side sees, because they typically outsource their collateral management solutions and once we move to a centralized counterparty, CCP, we see that margining actually happens at a much faster rate. So it goes from sometimes weekly to what the buy-sides doing now, to intraday, so the one risk they have going into this centralized clearing world is an increased cost of margining since a lot of third party solutions charge on volume of margin call frequency.

In terms of overall, one of the biggest risks that I see and a lot of people have identified is once we make everything collateralized or a whole swath of the OTC world collateralized, it’s actually going to be a big liquidity drain because a centralized counterparties only mandate very high quality collateral, so that’s cash or sovereigns. So if you look at the amount of collateral that’s going to have to be transferred into the margin accounts, that’s going to be a big risk for the liquidity in the financial institutions.

Jockle: Tom I want to thank you so much for your time. And please feel free to connect with Tom on LinkedIn and on Twitter as well as Numerix @nxanalytics or on our blog. We’d like to hear your feedback and talk about the topics you want to hear about. Thank you Tom and enjoy your sunny Vancouver day, and we’ll catch you on the pages of Numerix next time. Thanks Tom.

Davis: Thanks.  

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