Prudent Valuation: Bridging the Gap Between Pricing & Risk Management

Traditionally, quantitative finance practitioners are divided into two populations: those who seek fair values, i.e. means of price distributions, and those who seek risk measures, i.e. quantiles of price distributions. Fair value people and risk people typically live in separate lands, and worship different gods: the profit and loss balance sheet, and regulatory capital, respectively.

Prudent Valuation is a rather unexplored midland which has recently emerged somewhere in between the well known mainlands of Pricing and Risk Management. In fact, the Capital Requirements Regulation (CRR) forces financial institutions to apply prudent valuation to all fair value positions. The difference between the prudent value and the fair value, called Additional Valuation Adjustment (AVA), is directly deducted from the Core Equity Tier 1 (CET1) capital. On March 31st 2014, the European Banking Authority (EBA) published a draft Regulatory Technical Standards (RTS) for prudent valuation, to be approved by the EU Commission.

The 90% confidence level required by regulators for prudent valuation links quantiles of distributions of fair values (exit prices) to capital, thus bridging the gap between the Pricing and Risk Management mainlands, and forcing the crossbreeding of the fair value and risk populations.

On Wednesday, November 12th featured speakers and prudent value explorers Dr. Marco Bianchetti of Intesa Sanpaolo and Ilja Faerman of Numerix, discuss the new Prudent Valuation regulations, interpret the numerous AVAs and examine their calculations, and discuss best practices in implementing a Prudent Valuation framework.

Dr. Bianchetti and Mr. Faerman delved into the following topics:

  • Overview of Prudent Valuation regulations
    • Prudent valuation timeline
    • The Capital Requirement Regulation 575/2013
    • The EBA Regulatory Technical Standards: prudent valuation scope and approaches
  • Additional Valuation Adjustment (AVA) calculations
    • Definitions and basic assumptions for each AVA
    • Case studies and examples
    • Focus on Model Risk AVA
                 -  Sensitivity of prices to different models
                 -  Example with HW1F, CIR, BK and LMM models
                 -  Handling negative rates
  • Prudent Valuation framework
    • Implementation
    • Methodological framework
    • Operational framework
    • IT framework
    • Documentation & reporting
    • Example of prudent valuation framework

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