Counterparty Credit Risk - Wrong Way and Funding Issues

Counterparty Wrong Ways Risk
Liquidity and Counterparty Risks
Counterparty Risk
-
wrong way risk and liquidity issues
Antonio Castagna
antonio.castagna@iasonltd.com
-
www.iasonltd.com
2011
Iason 2011 - All rights reserved

Index
1 Counterparty Wrong Ways Risk

Contract Exposure and Default Probabilities
CVA and VaR with wrong-way risk
2 Liquidity and Counterparty Risks

Liquidity Risk Pricing in OTC Derivatives

Counterparty Wrong Ways Risk Contract Exposure and Default Probabilities
Liquidity and Counterparty Risks CVA and VaR with wrong-way risk
Index



Definition
Counterparty risk is the risk that a party to an OTC derivative

contract may fail to perform on its contractual obligations, causing
losses to the other party.
Losses are usually quantified in terms of the replacement cost of the
defaulted derivatives .
Counterparty risk can be:
1 One-Way: One party faces the exposures depending on the (ever
positive) value of the position it holds against the other party;
2 Two-Way: Both parties may face exposures depending on the value
of the positions they hold against each other.
The feature distinguishing counterparty risk from lending risk is
uncertainty of exposure at any future date:
1 Loan: exposure at any future date is the outstanding balance, which
is certain (not taking into account prepayments);
2 Derivative: exposure at any future date is the replacement cost,
which is determined by the market value at that date and is,
therefore, uncertain.

Index



Counterparty Risk Exposure of a Contract

We start by assuming that no netting or margin agreement is in
place.
The market value of contract i with a counterparty is known only for
the current date t = 0. For any future date t, the value Vi (t) is
random.
If the counterparty defaults at time τcpt before the contract’s
maturity, the economic loss is equal to the replacement cost of the
contract:
if Vi (τcpt ) > 0, we do not receive anything from defaulting
counterparty, but have to pay Vi (taucpt ) to another counterparty to
replace the contract;
if Vi (τcpt ) < 0, we receive |Vi (τcpt )| from another counterparty, but
have to give this amount to the defaulting counterparty.
Combining these two scenarios, we can specify contract-level
exposure Ei (t) at time t as:
Ei (t) = max[Vi (t), 0]

Counterparty Risk Exposure of a Contract
At a future time T > t, the exposure is uncertain:

Theoretical Approaches to Default Modelling
The second building block of the Counterparty Risk measurement is

the prediction of the default of the counterparty.
Jointly to the contract and portfolio level exposure, default
determines the counterparty risk fully.
In theoretical literature two approaches to model single defaults:
Structural Models: Default occurs as soon as the firm value crosses
a given barrier (from above)
Reduced (Intensity-based) Models: The default time is modelled
as the first jump time of a given jump process (typically a Poisson
process), occurring with an intensity λ(t), also called hazard rate.
This is the probability of a default occurring at an infinitesimal time
after t given that it did not occur before, and can be a stochastic
process itself.

Index



Wrong/Right-Way Risk
Wrong/right-way risk arises from dependence between credit quality of a
counterparty and exposure to that counterparty.
The risk is wrong (right) way when the exposure tends to increase
(decrease) when counterparty credit quality worsens.
Wrong/right-way risk can be general (dependence caused by systematic
risk factors) or specific (dependence caused by counterparty-specific risk
factors).
Some examples:
1 We sell credit protection on X to Y: general right-way
2 We enter into oil receiver swap with oil producer: general wrong-way
3 We buy a put option on X stock from Y: general wrong-way
4 We buy a put option on X stock from X: specific wrong-way
Specific wrong-way risk should be avoided.
We analyse the impact of wrong-way risk for a swap portfolio on:
The CVA adjustment for the risk-free value of a portfolio of swap, to
account for the expected losses given the default of the counterparty;
The counterparty credit VaR.
Theoretical Framework to Include Wrong-Way Risk
We assume that the default probability of the counterparty is stochastic

over the reference period.
Default is a jump whose probability of occurrence is determined by an
intensity λ(t), which is a stochastic process.
Roughly speaking, the intensity indicates the annual probability of default,
so that if λ(t) = 2%, there is a 2% probability that our counterparty will
go defaulted in next year. In our framework, the intensity varies over time,
so that the defalt probability is not constant.
The Expected positive exposure (EPE) of a swap is computed assuming
that all Euribor/Libor rates have a terminal Lognormal distribution. It is
possible to determine the distribution of the swap rates from the
distributions of the single Euribor/Libor rates (an analytical approximation
is used in our framework)
We correlate the default intensity with the swap rates, and we derive
analytical approximation for the expected losses (EPE × PD). We tested
this approximation against Montecarlo simulations and we found it very
accurate.

Credit Value Adjustment

The Credit Valuation Adjustment (CVA) of an OTC derivatives
portfolio with a given counterparty is the risk-neutral expectation of
the discounted loss of value of the portfolio, due to default by the
counterparty
Tn
X
CVA = Sprd · P(t, tk ) · EPE(tk ) · ∆tk
k=1
Sprd ≈ PD × LGD is the CDS spread dealing in the market for the
counterparty’s debt.
CVA can be computed analytically only at the contract level for
several simple cases.
Calculating discounted EPE at the counterparty level requires
simulation.
The market value of a portfolio of derivatives with a risky
counterparty is given by the risk-free market value minus the
relevant CVA, as defined above.
A Practical Example: Market Data
We show an example, assuming the following market data for interest

rates:
Time Eonia Fwd Sread Fwd Libor
0 0.75% 0.65% 1.40%
0.5 0.75% 0.64% 1.39%
1 1.75% 0.64% 2.39%
1.5 2.00% 0.63% 2.63%
2 2.25% 0.63% 2.88% 5.00%
2.5 2.37% 0.62% 2.99% 4.50%
3 2.50% 0.61% 3.11% 4.00%
3.5 2.65% 0.61% 3.26% 3.50%
4 2.75% 0.60% 3.35% 3.00%
Euribor Fw d
4.5 2.87% 0.60% 3.47% 2.50%
Eonia Fw d
5 3.00% 0.59% 3.59% 2.00%
5.5 3.10% 0.59% 3.69% 1.50%
6 3.20% 0.58% 3.78% 1.00%
6.5 3.30% 0.58% 3.88% 0.50%
7 3.40% 0.57% 3.97% 0.00%
7.5 3.50% 0.57% 4.07% 0 1 1.5 2 2.5 3 3.5 4 4.5 5 5.5 6 6.5 7 7.5 8 8.5 9
8 3.60% 0.56% 4.16%
8.5 3.67% 0.56% 4.23%
9 3.75% 0.55% 4.30%
9.5 3.82% 0.55% 4.37%
10 3.90% 0.54% 4.44%

A Practical Example: Market Data

Market data for caps&floors and swaptions volatilities are:
Caps&Floors Swaptions
Expiry Volatility Expiry Tenor Volatility
0.5 30.00% 0.5 9.5 27.95%
1 40.00% 1 9 28.00%
1.5 45.00% 1.5 8.5 27.69%
2 40.00% 2 8 27.09%
2.5 35.00% 2.5 7.5 26.61%
3 32.00% 3 7 26.32%
3.5 31.00% 3.5 6.5 26.16%
4 30.00% 4 6 26.02%
4.5 29.50% 4.5 5.5 25.90%
5 29.00% 5 5 25.79%
5.5 28.50% 5.5 4.5 25.68%
6 28.00% 6 4 25.57%
6.5 27.50% 6.5 3.5 25.46%
7 27.00% 7 3 25.37%
7.5 26.50% 7.5 2.5 25.28%
8 26.00% 8 2 25.22%
8.5 25.50% 8.5 1.5 25.21%
9 25.50% 9 1 25.34%
9.5 25.50% 9.5 0.5 25.50%
10 25.50% 10 0

A Practical Example: Default Probabilities
We assume that default is a jump oc- Years

1
PD
2.94%
curring with an intensity λ following 2
3
5.72%
8.34%
a CIR process: 4 10.80%
5 13.13%
6 15.35%
7 17.48%
8 19.53%
√ 9 21.52%
dλt = κ(θ − λt )dt + ν λt dZt 10 23.44%
Parameters are chosen to be:

25.00%
λ0 3.0% 20.00%
κ 27.0%
15.00%
θ 3.0% PD
ν 20.0% 10.00%
5.00%
The resulting PD are shown beside. 0.00%

1 2 3 4 5 6 7 8 9 10

A Practical Example: Constant Notional Portfolio
We compute the CVA for different levels of

correlation (nil=-0%, medium=-50%, high=-90%),
We analyse how the CVA is affected by and for different levels of the synthetic swap rate
different levels of correlation between the (at-the-money, in-the-money=ATM+1%,
(synthetic) swap rate of the portfolio and out-of-the-money=ATM-1%).
the intensity of default. The portfolio of
swaps has a constant notional amount Corr Swap- OTM ATM ITM
over next 10 years as shown below and Def.Intens. 1.63% 2.63% 3.63%
it is a net receiver fixed rate. 0% 0.0362 0.2853 0.8621
-50% 0.0788 0.4905 1.2640
-90% 0.1130 0.6546 1.5856
Years Notional
1 100.00
2 100.00 Adjustment over the risk-free swap rate to include
3 100.00
4 100.00
the counterparty risk.
5 100.00
6 100.00
7 100.00 Corr Swap- OTM ATM ITM
8 100.00 Def.Intens. 1.63% 2.63% 3.63%
9 100.00
10 100.00 0% 1.6341% 2.6621% 3.7271%
-50% 1.6389% 2.6853% 3.7724%
-90% 1.6427% 2.7037% 3.8086%

A Practical Example: Constant Notional Portfolio

Expected Positive Exposure (OTM,ATM,ITM) Expected Loss Given Default (OTM,ATM,ITM)
0.30000 0.025
0.25000
0.02
0.20000
0.015
ELgd Zero Corr
0.15000 EPE ELgd Medium Corr
ELgd High Corr
0.01
0.10000
0.005
0.05000
-
0
1 2 3 4 5 6 7 8 9 1 2 3 4 5 6 7 8 9
2.00000 0.12
1.80000
0.1
1.60000
1.40000
0.08
1.20000
ELgd Zero Corr
1.00000 EPE 0.06 ELgd Medium Corr
ELgd High Corr
0.80000
0.04
0.60000
0.40000
0.02
0.20000
-
0
1 2 3 4 5 6 7 8 9 1 2 3 4 5 6 7 8 9
8.00000 0.35
7.00000 0.3
6.00000
0.25
5.00000
0.2
ELgd Zero Corr
ELgd High Corr
0.15
3.00000
0.1
2.00000
1.00000 0.05
-
0
1 2 3 4 5 6 7 8 9 1 2 3 4 5 6 7 8 9

A Practical Example: Decreasing Notional Portfolio

The same analysis on how the CVA is and for different levels of the synthetic swap rate
affected by different levels of correlation (at-the-money, in-the-money=ATM+1%,
between the (synthetic) swap rate of the out-of-the-money=ATM-1%).
portfolio and the intensity of default, is
performed for a declining notional swap Corr Swap- OTM ATM ITM
portfolio over next 10 years, as shown Def.Intens. 1.63% 2.63% 3.63%
below. It is a net receiver fixed rate. 0% 0.0168 0.1420 0.4020
-50% 0.0345 0.2250 0.5526
-90% 0.0486 0.2914 0.6731
Years Notional
1 100.00
3 80.00
4 70.00
5 60.00
6 50.00
8 30.00 Def.Intens. 1.63% 2.63% 3.63%
9 20.00
10 10.00 0% 1.6333% 2.6579% 3.7089%
-50% 1.6368% 2.6742% 3.7385%
-90% 1.6395% 2.6872% 3.7622%

A Practical Example: Decreasing Notional Portfolio

5.00000 0.2
4.50000 0.18
4.00000 0.16
3.50000 0.14
3.00000 0.12
ELgd Zero Corr
ELgd High Corr
2.00000 0.08
1.50000 0.06
1.00000 0.04
0.50000 0.02
-
0
1 2 3 4 5 6 7 8 9 1 2 3 4 5 6 7 8 9
1.60000 0.07
1.40000 0.06
1.20000
0.05
1.00000
0.04
ELgd Zero Corr
ELgd High Corr
0.03
0.60000
0.02
0.40000
0.20000 0.01
-
0
1 2 3 4 5 6 7 8 9 1 2 3 4 5 6 7 8 9
0.14000 0.01
0.009
0.12000
0.008
0.10000 0.007
0.006
0.08000
ELgd Zero Corr
EPE 0.005 ELgd Medium Corr
ELgd High Corr
0.06000
0.004
0.04000 0.003
0.002
0.02000
0.001
-
0
1 2 3 4 5 6 7 8 9 1 2 3 4 5 6 7 8 9

A Practical Example: Increasing Notional Portfolio

Finally we operate the analysis on how and for different levels of the synthetic swap rate
the CVA is affected by different levels of (at-the-money, in-the-money=ATM+1%,
correlation between the (synthetic) swap out-of-the-money=ATM-1%).
rate of the portfolio and the intensity of
default, for an increasing notional swap Corr Swap- OTM ATM ITM
portfolio over next 10 years, as shown Def.Intens. 1.63% 2.63% 3.63%
below. It is still a net receiver fixed rate. 0% 0.0569 0.1825 0.5539
-50% 0.0817 0.3266 0.8450
-90% 0.0888 0.4419 1.0778
Years Notional
1 10.00
3 30.00
4 40.00
5 50.00
6 60.00
8 80.00 Def.Intens. 1.63% 2.63% 3.63%
9 90.00
10 100.00 0% 1.6355% 2.6691% 3.7486%
-50% 1.6422% 2.6999% 3.8109%
-90% 1.6475% 2.7246% 3.8607%

A Practical Example: Increasing Notional Portfolio

3.50000 0.2
0.18
3.00000
0.16
2.50000 0.14
0.12
2.00000
ELgd Zero Corr
ELgd High Corr
1.50000
0.08
1.00000 0.06
0.04
0.50000
0.02
-
0
1 2 3 4 5 6 7 8 9 1 2 3 4 5 6 7 8 9
1.20000 0.08
0.07
1.00000
0.06
0.80000
0.05
ELgd Zero Corr

ELgd High Corr
0.03
0.40000
0.02
0.20000
0.01
-
0
1 2 3 4 5 6 7 8 9 1 2 3 4 5 6 7 8 9
0.25000 0.016
0.014
0.20000
0.012
0.01
0.15000
ELgd Zero Corr
ELgd High Corr
0.10000
0.006
0.004
0.05000
0.002
-
0
1 2 3 4 5 6 7 8 9 1 2 3 4 5 6 7 8 9

Basel II Regulation: the IMM
IMM approach is the most suited to properly take into account the
market risks related to a given counterparty’s portfolio
The building blocks of the IMM approach:
definition of a set of statistics for internal and regulatory purposes
identification of market factors and generation of future scenarios
pricing algorithms to price the contracts included in the books
aggregation rules to evaluate the effects of the risk mitigation
agreements
a framework modelling the credit risk of the counterparties, the
correlations amongst them and the correlation of counterparties with
market risks to measure the “full” counterparty risk
calculation of the counterparty exposure measures, i.e. its risk profile,
credit value adjustment, economic and regulatory capital

Exposure Measures in the IMM Method
Starting from exposure for each counterparty we can define other

statistics and risk measures:
Expected exposure (EE )

EEi (tk ) = E max[Vi (tk ), 0]
Expected positive exposure (EPE)
k
1 X
EPEi (tk ) = EEi (tj )(tj − tj−1 )
tk − t0 j=1
Effective Maturity M
ΣTk=1 Df (tk ) · EPEi (tk )

M = min t ≤1Y
,5
Σk=1
k
Df (tk ) · EPE (tk )

Regulatory Capital
The Regulatory Capital (RC ) is computed by means of the following

quantities
1 EPE
2 The α factor (ratio of the EC calculated with full simulation, to the
EC calculated with a constant exposure equal to EPE )
3 The Effective EPE (E EPE), which takes into account the roll-off risk
E EPE(tk ) = max[E EPE(tk−1 ), EPE(tk )]
and it is actually the counterparty exposure measure which the RC
is computed upon
The α factor is calculated on a given time interval, but kept
constant otherwise. The period between two calculations depends on
the granularity and the time evolution of the portfolio

Regulatory Capital
For regulatory purposes, the capital can be determined as follows:
MCR = α × E EPE × RW × 8%
dove RW = 12.5 × K and
!
N −1 (PDi ) + ri N −1 (0.999)
K = LGD N p − LGD × PDi
1 − ri2
PDi = default probability for counterparty i

LGD = loss given default
ri = systemic risk load factor, also indicated by the Regulation equal
to:
0.12×(1−e (−50×PD) )/(1−e −50 )+0.24×[1−(1−e (−50×PD) )/(1−e −50 )]
α has to be estimated according to an internal model approved by the
Surveillance Authority (with a 1.20 minimum), otherwise it has to be set
equal to 1.40.
Regulatory Capital and Wrong-Way Risk
We aim at introducing the wrong-way risk also in the counterparty credit

VaR calculation.
The idea is still to have a “loan equivalent” of the exposure, so that we
can adjust the EPE or the E EPE measure to input into the regulatory
formula.
A possible approach to apply to the framework outlined above to compute
the VaR is:
Compute the stressed (99.9% c.l.) PD according to the supervisory
formulae;
Deduce which is the level of the default intensity consistent with the
stressed PD;
Compute the conditioned mean and variance of the risk factors
determining the exposure of the derivative contracts;
Compute the new EPE with the conditioned mean and variance;
Calculate the wrong-way-adjusted Economic Capital with the new
EPE or the corresponding E EPE.

Counterparty Credit VaR: an Example

We analyze a swap portfolio expiring in 1 year, with monthly interest rate
exchanges. The portfolio is net receiver fixed rate.
The counterparty has a PD = 2.94% in next year, and this is produced by
a jump process whose intensity is a stocahstic process with parameters
seen above. We test 3 versions: constant (P1), moderately decreasing
(P2) and incresing (P3) notional.
According to the supervisory formula, the stressed PD at a 99.9% c.l. is
22.34%.
Market rates and volatilities:
Months Eonia 1M Libor Libor Vol Months P1 P2 P3

1 0.79% 0.99% 34.00% 1 100 100 45
2 0.82% 1.02% 34.50% 2 100 95 50
3 0.85% 1.05% 35.00% 3 100 90 55
4 0.87% 1.07% 35.50% 4 100 85 60
5 0.90% 1.10% 36.00% 5 100 80 65
6 0.92% 1.12% 36.50% 6 100 75 70
7 0.95% 1.15% 37.00% 7 100 70 75
8 0.97% 1.17% 37.50% 8 100 65 80
9 1.00% 1.20% 38.00% 9 100 60 85
10 1.02% 1.22% 38.50% 10 100 55 90
11 1.05% 1.25% 39.00% 11 100 50 95
12 1.07% 1.27% 39.50% 12 100 45 100


EPE and E EPE (OTM,ATM,ITM)
0.35000
Portfolio P1 (Constant Notional). 0.30000
Tables below show the effective EPE for 0.25000
different levels of correlation and average 0.20000

EPE
EPE WV
EEPE WV
fixed rate of the portfolio, and the ratio 0.15000

EEPE
0.10000
(α) with the 0-correlation case. 0.05000
Beside the figures show the EPE and the -
effective EPE for a correlation of −10%, 0.08 0.17 0.25 0.33 0.42 0.50 0.58 0.67 0.75 0.83 0.92
for the three fixed rate values indicated 0.10000
in the tables. 0.09000
0.08000
0.07000
0.06000 EPE
OTM ATM ITM 0.05000
EPE WV
EEPE WV
Corr Swap-Def.Intens. 0.85% 1.10% 1.35% 0.04000 EEPE
0% 0.0045 0.0426 0.2120 0.03000
-5% 0.0067 0.0610 0.2578 0.02000
-10% 0.0096 0.0881 0.3024 0.01000
-
0.08 0.17 0.25 0.33 0.42 0.50 0.58 0.67 0.75 0.83 0.92
0.01400
0.01200
OTM ATM ITM
Corr Swap-Def.Intens. 0.85% 1.10% 1.35% 0.01000
0% 1.00 1.00 1.00 0.00800

EPE
EPE WV
-5% 1.47 1.43 1.22 0.00600
EEPE WV
EEPE
-10% 2.12 2.07 1.43
0.00400
0.00200
-
0.08 0.17 0.25 0.33 0.42 0.50 0.58 0.67 0.75 0.83 0.92


0.25000
Portfolio P2 (Decreasing Notional).

different levels of correlation and average 0.15000 EPE

EPE WV
EEPE WV
fixed rate of the portfolio, and the ratio 0.10000 EEPE
0.05000
EPE
OTM ATM ITM 0.04000
EPE WV
EEPE WV
Corr Swap-Def.Intens. 0.84% 1.09% 1.34% 0.03000
EEPE
0% 0.0024 0.0282 0.1533 0.02000
-5% 0.0036 0.0428 0.1849

0.01000
-10% 0.0054 0.0642 0.2155
-
0.08 0.17 0.25 0.33 0.42 0.50 0.58 0.67 0.75 0.83 0.92
0.00800
0.00700
OTM ATM ITM
0.00600
Corr Swap-Def.Intens. 0.84% 1.09% 1.34%
0.00500
0% 1.00 1.00 1.00 EPE
EPE WV
-5% 1.50 1.52 1.21 0.00400
EEPE WV
EEPE
-10% 2.23 2.27 1.41 0.00300
0.00200
0.00100
-
0.08 0.17 0.25 0.33 0.42 0.50 0.58 0.67 0.75 0.83 0.92


0.25000
Portfolio P3 (Increasing Notional).

different levels of correlation and average 0.15000 EPE

EPE WV
EEPE WV
fixed rate of the portfolio, and the ratio 0.10000 EEPE
0.06000
0.05000
EPE
OTM ATM ITM 0.04000
EPE WV
EEPE WV
Corr Swap-Def.Intens. 0.88% 1.13% 1.38% EEPE
0.03000
0% 0.0052 0.0403 0.1677

0.02000
-5% 0.0076 0.0555 0.2029
0.01000
-10% 0.0107 0.0755 0.2371
-
0.08 0.17 0.25 0.33 0.42 0.50 0.58 0.67 0.75 0.83 0.92
0.01600
0.01400
OTM ATM ITM
0.01200
Corr Swap-Def.Intens. 0.88% 1.13% 1.38%
0.01000
0% 1.00 1.00 1.00 EPE
EPE WV
-5% 1.44 1.38 1.21 0.00800
EEPE WV
EEPE
-10% 2.05 1.87 1.41 0.00600
0.00400
0.00200
-
0.08 0.17 0.25 0.33 0.42 0.50 0.58 0.67 0.75 0.83 0.92

Counterparty Credit VaR: Some Conclusions

The experiments we have presented above seem to show that, at least as
far as the wrong-way risk is concerned, the regulatory coefficient α is in
many cases too low. This is even more evident if consider the fact that we
chose very small value for the correlation.
Actually, the stressed PD’s in a Merton (Gaussian copula) approach, such
as the regulatory one, are determined by the stressed level of a common
factor affecting all the debtors and producing a correlation amongst
defaults.
The correlation with respect to this factor does not need to be the same
as the correlation between the single total PD and market risk factors (in
our examples, the swap rates) and it is likely lower than the correlation
with the specific factors, although not always this is the case.
We have not explored in the analysis this extension, but it would be
straightforward to set the default intensity of each conuterparty as:
λD = λi + p i × λC
where λC is an intensity process common to all counterparties and λi is

specific to each counterparty.
Counterparty Credit VaR: Some Conclusions

The α (for the part due to the wrong-way) is also a function of the
features of the portfolio of contracts with a counterparty, in terms of
average fixed rate received (or paid) and evolution of the aggregated
notional over time. The main finding is that one α good for all occasions
is not a wise choice.
When considering also the correlation amongst the defaults of all the
counterparties, some diversification effects may be expected, so that the α
can actually be lower than 1.40 which is the standard level set by
regulation if the bank is not able to compute a full deployed VaR.
To introduce a rich structure of correlation amongst counterparties’
defaults, the regulatory formula has to be enhanced so as to include more
factors. Extensions of the Merton’s (Gaussian copula) approach are
available and some of them can be effectively solved in very good analytic
approximations.
It is important to check which is the real contribution of the correlations
to the Economic Capital for management purposes. For regulatory
purposes, the proposed α = 1.40 seems to be very favorable to banks to
save allocated capital.
Index



Collateral and Margin Agreements
Collateral agreement is a contract between two counterparties that

requires one or both counterparties to post collateral (typically cash or
high quality bonds) under certain conditions.
Margin agreement is a legally binding collateral agreement with specific
rules for posting collateral, which include:
1 Minimum transfer amount: defines the minimum amount of
collateral that can be exchanged. If the exposure entails a collateral
posting below the minimum, amount, no collateral is provided;
2 A threshold, defined for one (unilateral agreement) or both (bilateral
agreement) counterparties. If the difference between the net portfolio
value and already posted collateral exceeds the threshold, the
counterparty must provide collateral sufficient to cover this excess
(subject to minimum transfer amount);
3 Frequency: defines the periodicity of the exposure calculation and of
the determination of the collateral to post.
The terms of the rules depend mainly on the credit qualities of the
counterparties involved.

Index



Pricing OTC Derivatives with CSA

In a very general fashion, the price at time 0 of a derivatives contract
which is not subject to counterparty risk is:
R
T
V0 = E Q e − 0 rs ds VT
where
VT is the terminal pay-off of the contract;
rt is the (possibly time dependent) risk-free interest rate.
When counterpaty risk is considered, then we have to include the so called
CVA (the expected losses we suffer when on default of the counterparty)
the and DVA (the expected losses the counterparty suffers on our default):
R
T
V0CCP = E Q e − 0 rs ds VT − CVA + DVA
The terminal value of the contract is still discounted ad the risk-free rate
rt , but then the price is adjusted with the net effect due to the losses
upon default of the two counterparties involved in the trade.
Assume now we have a CSA agreement operating between the two

counterparties. The CSA provides for a daily margining mechanism of the
full variation of the NPV (nowadays a very common form of the CSA).
The party that owns a positive balance on the collateral account
(corresponding to a positive NPV of the contract) pays the rate ct to the
other party.
The pricing of the contract can be now be operated by excluding the
default risk (there is still a very small residual risk between two daily
margining).
It can be shown that the pricing formula is very similar to the standard
case we have seen above, but with the collateral rate ct replacing the
risk-free rate rt .:
R
T
V0CSA = E Q e − 0 cs ds VT (1)


This result is very convenient, since we have a well defined rate that has
to be paid on the collateral balance (set within the contract), whereas the
risk-free rate is very difficult to determine in the current market
environment (it used to be the Libor in the interbank market).
Usually the daily margined CSA agreements set the remuneration of the
collateral at the EONIA for contracts in euro (or some equivalent OIS rate
for other currencies). EONIA (OIS) rates can be considered the best
approximation of a risk-free rate.
Nevertheless there is still one assumption that is made when deriving the
pricing formula with the CSA:
The rate at which the bank can lend money is the same of the one it
can borrow money.
This assumption can be easily relaxed when we price contracts whose
NPV can be always either positive or negative (e.g.: a long or a short
position on an option contract).
When the NPV of the contract can switch from positive to negative
and/or from negative to positive (e.g.: forward and swap contracts) then
relaxing the assumption is trickier.
Assume we have a contract whose value during the life of the contract at
any time 0 < t < T , Vt can be positive or negative.
We also assume that the bank can invest cash at a risk-free rate equal to
the collateral rate rt = ct , but it has a funding spread ft when borrowing
money over a short period, so that the total funding cost is rt + ft .
When considering the funding spread in the pricing of a collateralized
derivatives contract, it can be shown that the valuation equation can be
written as:
R R
T T
V0CSA = E Q e − 0 cu −fu 1{Vu <0} du VT = E Q e − 0 cu du VT + LVA (2)
where
T Rs
Z
LVA = E Q e− 0 cu du min(Vs (0), 0)fs ds (3)
0


Equation (3) can be computed numerically with a good degree of
approximation: it accounts for the funding cost that the bank has to pay
when financing the cash injection in the collateral account, expressed has
a spread ft over the risk-free rate rt = ct , which on the contrary is the rate
the bank can invest at. We name this quantity Liquidity Value Adjustment
(LVA)
As an example, when we price a (K -fix rate receiver) swap contract
starting in ti and ending in T = tN , the minimum value of the contract is
min(Vt , 0) = − min(−Vt , 0) = − max(Si,n − K , 0).
Assume we divide the period between the evaluation time t0 = 0 and the
expiry in N intervals. The LVA can be written as:
N
X
LVASwp = − Pay(ti ; ti , T , K )fti ∆ti (4)
i=1
where Pay is the value of a payer swaption struck at K , expiring in ti and

written on a swap starting in ti and maturing in T .

A Practical Example
We show an example, assuming the following market data for interest

rates:
Time Eonia Fwd Spread Fwd Libor
0 0.75% 0.65% 1.40%
0.5 0.75% 0.64% 1.39%
1 1.75% 0.64% 2.39%
1.5 2.00% 0.63% 2.63%
2 2.25% 0.63% 2.88% 5.00%
2.5 2.37% 0.62% 2.99% 4.50%
3 2.50% 0.61% 3.11% 4.00%
3.5 2.65% 0.61% 3.26% 3.50%
4 2.75% 0.60% 3.35% 3.00%
Euribor Fw d
4.5 2.87% 0.60% 3.47% 2.50%
Eonia Fw d
5 3.00% 0.59% 3.59% 2.00%
5.5 3.10% 0.59% 3.69% 1.50%
6 3.20% 0.58% 3.78% 1.00%
6.5 3.30% 0.58% 3.88% 0.50%
7 3.40% 0.57% 3.97% 0.00%
7.5 3.50% 0.57% 4.07% 0 1 1.5 2 2.5 3 3.5 4 4.5 5 5.5 6 6.5 7 7.5 8 8.5 9
8 3.60% 0.56% 4.16%
8.5 3.67% 0.56% 4.23%
9 3.75% 0.55% 4.30%
9.5 3.82% 0.55% 4.37%
10 3.90% 0.54% 4.44%

A Practical Example
Market data for caps&floors and swaptions volatilities are:
Caps&Floors Swaptions
Expiry Volatility Expiry Tenor Volatility
0.5 30.00% 0.5 9.5 27.95%
1 40.00% 1 9 28.00%
1.5 45.00% 1.5 8.5 27.69%
2 40.00% 2 8 27.09%
2.5 35.00% 2.5 7.5 26.61%
3 32.00% 3 7 26.32%
3.5 31.00% 3.5 6.5 26.16%
4 30.00% 4 6 26.02%
4.5 29.50% 4.5 5.5 25.90%
5 29.00% 5 5 25.79%
5.5 28.50% 5.5 4.5 25.68%
6 28.00% 6 4 25.57%
6.5 27.50% 6.5 3.5 25.46%
7 27.00% 7 3 25.37%
7.5 26.50% 7.5 2.5 25.28%
8 26.00% 8 2 25.22%
8.5 25.50% 8.5 1.5 25.21%
9 25.50% 9 1 25.34%
9.5 25.50% 9.5 0.5 25.50%
10 25.50% 10 0

A Practical Example: Collateralized Swap
We price under a CSA agreement a

receiver swap whereby we we pay the LVA -0.0512%
Libor fixing semi-annually (set at the Fair Swap rate 3.3020%
previous payment date) and we re- Swap Rate + Coll. Fund 3.3079%
ceive the fixed rate annually. With Difference 0.0059%
market data shown above, the fair
rate can be easily calculated (we are ENE
using the new market standard ap- -

0.5 1 1.5 2 2.5 3 3.5 4 4.5 5 5.5 6 6.5 7 7.5 8 8.5 9 9.5
(1.0000)
proach to employ the EONIA/OIS (2.0000)
curve for discounting and the 6M Li- (3.0000)
bor curve to project forward rates). (4.0000)
We assume also that we have to pay (5.0000)
a funding spread of 15bps over the (6.0000)
EONIA/OIS curve. This is applied to (7.0000)
the ENE plotted beside.

A Practical Example: Collateralized Swap
We may be interested in calculat-

ing the impact of the liquidity of a
collateralized swap with respect to a LVA -0.2156%
more conservative measure than the Fair Swap rate 3.3020%
ENE, similarly to what happens in Swap Rate + Coll. Fund 3.3264%
the counterparty risk management. Difference 0.0244%
We choose the Potential Future Ex-
posure, which is the expected nega- -
0.5 1 1.5 2 2.5 3 3.5 4 4.5 5 5.5 6 6.5 7 7.5 8 8.5 9 9.5
tive NPV of the swap at a given level (5.0000)
of confidence, set in this example at (10.0000)
the 99% and computed with market (15.0000)

PFE
ENE
volatilities.
(20.0000)
The funding spread is still 15bps over

the EONIA/OIS curve. The Potential
(25.0000)
Future Exposure (blue line), and the (30.0000)
ENE (purple line, same as before) for

comparison, are plotted beside.

About Iason
Iason is a company created by market practitioners, financial quants and programmers

with valuable experience achieved in dealing rooms of financial institutions.
Iason offers a unique blend of skills and expertise in the understanding of financial
markets, in the pricing of complex financial instruments and in the measuring and the
management of banking risks. The company’s structure is very flexible and grants a
fully bespoke service to our Clients.
Iason believes the ability to develop new quantitative finance approaches through re-
search as well as apply those approaches in practice is critical to innovation in risk
management and derivatives pricing. It is bringing into the all the areas of the risk man-
agement a new and fresh approach based on the balance between rigour and efficiency
Iason’s people aimed at when working in the dealing rooms.
Besides tailor made services, Iason offers software applications to calculate and monitor
credit VaR and conterparty VaR, fund transfer pricing and loan pricing, liquidity-at-risk.
c
Iason - 2011
This is a Iason’s creation.
The ideas and the model frameworks described in this presentation are the fruit of the intellectual efforts and of the skills of the people
working in Iason. You may not reproduce or transmit any part of this document in any form or by any means, electronic or mechanical,
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Counterparty Wrong Ways Risk

Liquidity and Counterparty Risks

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1 Counterparty Wrong Ways Risk

2 Liquidity and Counterparty Risks

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1 Counterparty Wrong Ways Risk

2 Liquidity and Counterparty Risks

Iason 2011 - All rights reserved

Counterparty risk is the risk that a party to an OTC derivative

Iason 2011 - All rights reserved

1 Counterparty Wrong Ways Risk

2 Liquidity and Counterparty Risks

Iason 2011 - All rights reserved

Counterparty Risk Exposure of a Contract

Ei (t) = max[Vi (t), 0]

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Counterparty Risk Exposure of a Contract

At a future time T > t, the exposure is uncertain:

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Theoretical Approaches to Default Modelling

The second building block of the Counterparty Risk measurement is

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1 Counterparty Wrong Ways Risk

2 Liquidity and Counterparty Risks

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Theoretical Framework to Include Wrong-Way Risk

We assume that the default probability of the counterparty is stochastic

Iason 2011 - All rights reserved

Credit Value Adjustment

A Practical Example: Market Data

We show an example, assuming the following market data for interest

Iason 2011 - All rights reserved

A Practical Example: Market Data

Iason 2011 - All rights reserved

A Practical Example: Default Probabilities

We assume that default is a jump oc- Years

Parameters are chosen to be:

The resulting PD are shown beside. 0.00%

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A Practical Example: Constant Notional Portfolio

We compute the CVA for different levels of

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A Practical Example: Constant Notional Portfolio

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A Practical Example: Decreasing Notional Portfolio

We compute the CVA for different levels of

Iason 2011 - All rights reserved

A Practical Example: Decreasing Notional Portfolio

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A Practical Example: Increasing Notional Portfolio

We compute the CVA for different levels of

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A Practical Example: Increasing Notional Portfolio

ELgd Zero Corr

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Basel II Regulation: the IMM

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Exposure Measures in the IMM Method

Starting from exposure for each counterparty we can define other

Expected positive exposure (EPE)

ΣTk=1 Df (tk ) · EPEi (tk )

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The Regulatory Capital (RC ) is computed by means of the following