Counterparty risk is a function of contract valuation and funding for a swap contract. The authors explore facets of counterparty risk and funding as embodied in four linked formulas for credit value adjustment, debit value adjustment, liquidity value adjustment, and replacement cost. Their analysis is a formulaic supplement to previous research on these topics.
What’s Inside?
The authors explore the components that make up a total valuation adjustment (TVA) to reflect the risk borne by counterparties to a credit agreement. Their discussion is a high-level summary of previous theoretical research on the subject.
How Is This Research Useful to Practitioners?
The authors illustrate how the four parts, or “wings,” of a TVA can be jointly calculated under various scenarios, considering circumstances that facilitate deals and those that hinder deals. Credit risk and volatility figure importantly in valuation and thus in counterparty risk.
To define and explore the components that are considered in a TVA, the authors examine several types of swap contracts and their pricing using two distinct valuation models. The exercise is carried out under various credit support annex and model types.
Students and practitioners of risk management would find this research to be a succinct, although complex, expression of relevant conclusions concerning the intertwined components of counterparty risk and funding, as would bank executives who desire a more in-depth examination of how such arrangements affect their institutions’ profitability. Such practitioners with a quantitative background as financial engineers and actuaries would be best suited to grasp the conditions surrounding the authors’ numerous calculations and conclusions.
How Did the Authors Conduct This Research?
The authors’ investigation serves as a numeric and formulaic expression of previous research. Their point of departure is a netted portfolio of OTC (over-the-counter) derivatives between two counterparties capable of default. They then define the data for their research, which includes the risk-free rate of an overnight indexed swap and cash flows for funding the counterparty’s (a bank’s) position, the latter of which is an expression of liquidity and credit risk. Backward stochastic differential equations are used to derive the TVA.
A TVA consists of four separately interpretable, yet interdependent, components whose calculations must be carried out jointly. The authors evaluate conditions prior to and during default conditions and examine the circumstances that facilitate versus hinder the establishment and operation of a counterparty risk hedge. Interest rate derivatives examined include forward rate agreements, interest rate swaps, and caps. The pricing of these swap arrangements to evaluate TVA model risk is considered from the perspective of multiple valuation models. The authors conclude with an analysis and computation of a TVA and its components under various counterparty scenarios for a credit support annex or risk mitigation tool.
Abstractor’s Viewpoint
Practitioners with quantitative training would find this piece more accessible than those without such training. The latter group would do well to access the prior research on which this work is based. The crises in credit that investors experienced during the Great Recession and the recent and ongoing European sovereign debt crisis have motivated further study of relevant risk management principles to price and mitigate risk. The authors consider the interdependency of the constituents of a risk valuation model in an effort to better understand the various elements of counterparty risk, which is a subject of increased importance, given the complexity of financial institutions and their multifaceted exposures to different trading desks.