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
Featured Speakers
Marco Bianchetti, PhD
Marco Bianchetti joined the Market Risk Management area of Intesa Sanpaolo in 2008. His recent work covers derivative pricing and risk management across all asset classes, with a focus on new product development, model validation, model risk management, funding and counterparty risk, and Quasi Monte Carlo. Previously Dr. Bianchetti worked for 8 years in the front office Financial Engineering area of Banca Caboto (now Banca IMI), developing pricing models and applications for interest rate and inflation trading desks. He is a frequent speaker at international conferences and training sessions in quantitative finance. He holds an MSc in theoretical nuclear physics and a PhD in theoretical condensed matter physics.
Ilja Faerman serves as the Managing Director, Financial Engineering at Numerix, where he has spearheaded the successful delivery of projects across Europe, the Middle East, and Africa. His extensive expertise encompasses the pricing of complex derivatives across multiple asset classes, XVA desk support in building calculation infrastructure, and collaboration with structured product issuers on a wide array of processes, ranging from solutions for trade ideation to building platforms for comprehensive risk management of large portfolios. Faerman also possesses in-depth knowledge on various subjects, such as SIMM, FRTB, and buy-side industry solutions.
Before joining Numerix, Faerman gained valuable experience as a Financial Engineer and Model Validation Analyst at Thomson Reuters. He holds a Bachelor of Science degree in Business and Computer Science, as well as a Master of Science degree in Finance from the renowned Frankfurt School of Finance.
As Chief Marketing Officer and Executive Vice President of Global Marketing & Corporate Communications, James leads the company’s global marketing and corporate communications efforts, spanning a diverse set of solutions and audiences. He oversees integrated marketing communications to clients in the largest global financial markets and to the Numerix partner network through the company's branding, electronic marketing, research, events, public relations, advertising and relationship marketing.
Since joining Numerix in 2008, James has launched the organization’s award-winning thought leadership program, bringing to light challenges and insights from Numerix market experts. He also hosts the Numerix Video Blog, tackling the challenges pressing the derivatives markets—from regulatory issues to trading strategies.
Prior to joining Numerix, James served as Managing Director of Global Marketing and Communications for Fitch Ratings. During his tenure at Fitch, he built the firm’s public relations program, oversaw investor relations and led marketing and communications plans for several acquisitions. Prior to Fitch, James was a member of the communications team at Moody's Investors Service.
