Credit Valuation Adjustment Modelling in Theory and Practice

• Thesis title in Czech: Modelování CVA v teorii a praxi
• Thesis title in English: Credit Valuation Adjustment Modelling in Theory and Practice
• Academic year of topic announcement: 2013/2014
• Thesis type: diploma thesis
• Thesis language: angličtina
• Department: Institute of Economic Studies (23-IES)
• Supervisor: prof. PhDr. Petr Teplý, Ph.D.
• Author: hidden - assigned by the advisor
• Date of registration: 16.06.2014
• Date of assignment: 16.06.2014
• Date and time of defence: 23.09.2015 00:00
• Venue of defence: IES
• Date of electronic submission: 31.07.2015
• Date of proceeded defence: 23.09.2015
• Opponents: Mgr. Petra Buzková

Guidelines

Outline:
1. THEORETICAL BACKGROUND
 Counterparty credit risk
o Methods of CCR mitigation
 OTC market and derivatives
o Central Counterparties
 CVA concept
o Principles of CVA
o Accounting CVA
o Internal CVA
o CVA capital charge
 Basel III vs Basel II
 European exemption
 Standardized approach
 Advanced approach

2. EMPIRICAL PART
 Literature review
 Hypotheses
 Methodology
 Data description
 Modelling procedure
 Summary of results

References

1. Baldeaux, J. and Platen, E. (2013). Credit Derivative Evaluation and CVA under the Benchmark Approach. Research Paper Series 324, Quantitative Finance Research Centre, University of Technology, Sydney.
2. BCBS (2011). Basel III: A global regulatory framework for more resilient banks and banking systems.
3. Brigo, D., Morini, M., Pallavicini, A. (2013). Counterparty Credit Risk, Collateral and Funding: With Pricing Cases for All Asset Classes. John Wiley & Sons.
4. Cherubini, U. (2013). Credit valuation adjustment and wrong way risk. Quantitative Finance Letters, Vol. 1, No. 1, pp. 9-15.
5. Douglas R., Pugachevsky D., Gregory J. (2012). Comparing Alternate Methods for Calculating CVA Capital Charges under Basel III. Quantifi.
6. Fares, Ziad and Genest, Benoit (2013). CVA Capital Charge Under Basel III Standardized Approach.
7. Gregory, J., (2012). Counterparty credit risk and credit value adjustment: a continuing challenge for global financial markets. 2nd ed. Hoboken, N.J.: Wiley.
8. Janda, K. and Rausser G. (2011). Comparing American and European Regulation of Over-the-Counter Derivative Securities. European Financial and Accounting Journal, Vol. 6, No. 4, pp. 7-19.
9. Janda, K. et al., (2015-2017). Modeling Credit Risk for Financial and Commodity Assets Portfolios. Description of upcoming project granted by GA CR.
10. Pykhtin, M. (2012). Model foundations of the Basel III standardised CVA charge. Risk. 2012, 25(7): 60-66.

Preliminary scope of work

Credit risk is considered to be the most important of banks’ financial risks. Its subpart - counterparty credit risk (CCR) - constitutes a risk of counterparty’s default to fulfill obligations in bilateral contracts such as over-the-counter (OTC) derivatives. BSBC (2011) reported that: ‘During the financial crisis roughly two-thirds of losses attributed to CCR were due to CVA losses (mark-to-market losses) and only about one-third were due to actual defaults.’ Therefore, BCBS published Basel III in 2011 introducing CVA capital charge models for potential mark-to-market losses associated with deterioration in the credit worthiness of counterparties. The CVA capital charge quantifies the amount of capital that the banks are obliged to hold in relation to their OTC portfolios to serve as an additional capital buffer. In 2013 the CVA concept was introduced into accounting practices also, through the IFRS 13 Fair Value Measurement. According to Brigo (2013): ‘CVA measures the expected value of discounted loss that can occur in case of counterparty‘s default’. In other words, CVA quantifies the value of counterparty credit risk and decreases the value of derivatives by this amount. In summary, accounting CVA contributes to more prudent derivative valuation and the regulatory CVA increases capital requirements for institutions operating with OTC derivatives in their portfolio.

Although CVA was introduced three years ago, it still draws attention of regulators, professional public and banks, and is still being modified. Considering regulatory CVA, there are differences in implementation between the USA and Europe. In the latter case, the so called European exemption allows banks not to apply CVA for specific counterparties, therefore favouring European banks. The European Banking Authority (EBA) currently collects data from banks about their methods and models in order to advise the European Commission on possible amendments and to contribute to current discussions. Results will be reported in January 2015. In contrast to the regulatory CVA, accounting CVA models are not given by regulators and can be only approved by an auditor. CVA modelling is also used for internal purposes like risk management. A detailed analysis of issues regarding CRR and all CVA types is provided by Gregory (2012).

CVA can be viewed from two perspectives; macroeconomic and microeconomic. The former view explores CVA in context of systemic risk and contagion effects, while the latter examines CVA modelling itself applied by banks. This microeconomic perspective is the subject of my master thesis. As the accounting and internal CVA models are not strictly given and publicly known I have decided to concentrate on CVA capital charge with the two approaches specified in Basel III; standardized and advanced. Furthermore, modelling practices of CVA capital charge have a direct impact on a banks’ capital held. Except for the USA, banks cannot choose what approach to use as it depends on their approved internal models. However, different risk mitigators influence the resulting charges heavily in favour of the more challenging advanced approach. Comparison of the effect of hedges as risk mitigators on both methods was executed by Douglas et all. (2012). Pykhtin (2012) and Fares et all. (2013) explore the origin and the characteristics of the standardized formula.

Preliminary scope of work in English

Hypotheses:

1. The CVA capital charge under the advanced method is higher than under the standardized method when no risk mitigators are used.
2. The CVA capital charge under the advanced method is lower than under the standardized method when collateral, hedging or netting is used.
3. For two and more counterparties, the CVA capital charge under the advanced method increases with higher correlation between the counterparties.

Methodology:
Hypothetical portfolios will be constructed for a comparison of both standardized and advanced approach. They will range from simple portfolios to more realistic ones. Within the advanced method, computationally intensive Monte Carlo simulations will be used to model exposures. The evolution of the underlying risk factors will be modelled by stochastic processes. Real market data will help to define some characteristics of counterparties and to estimate correlations and volatilities of CDS spreads and market risk factors. Data sources like Bloomberg, Reuters, BIS, ISDA or EBA will be used.