A practical approach to XVA the evolution of derivatives valuation after the financial crisis

A PRACTICAL APPROACH TO The Evolution of Derivatives Valuation after the Financial Crisis 11057_9789813272736_TP.indd 7/5/19 9:41 AM b2530   International Strategic Relations and China’s National Security: World at the Crossroads This page intentionally left blank b2530_FM.indd 01-Sep-16 11:03:06 AM A PRACTICAL APPROACH TO The Evolution of Derivatives Valuation after the Financial Crisis Osamu Tsuchiya Simplex Inc., Japan World Scientific NEW JERSEY • LONDON 11057_9789813272736_TP.indd • SINGAPORE • BEIJING • SHANGHAI • HONG KONG • TAIPEI • CHENNAI • TOKYO 7/5/19 9:41 AM Published by World Scientific Publishing Co Pte Ltd Toh Tuck Link, Singapore 596224 USA office: 27 Warren Street, Suite 401-402, Hackensack, NJ 07601 UK office: 57 Shelton Street, Covent Garden, London WC2H 9HE British Library Cataloguing-in-Publication Data A catalogue record for this book is available from the British Library A  PRACTICAL  A PPROACH  TO  XVA The Evolution of Derivatives Valuation after the Financial Crisis Copyright © 2019 by World Scientific Publishing Co Pte Ltd All rights reserved This book, or parts thereof, may not be reproduced in any form or by any means, electronic or mechanical, including photocopying, recording or any information storage and retrieval system now known or to be invented, without written permission from the publisher For photocopying of material in this volume, please pay a copying fee through the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, USA In this case permission to photocopy is not required from the publisher ISBN 978-981-3272-73-6 For any available supplementary material, please visit https://www.worldscientific.com/worldscibooks/10.1142/11057#t=suppl Desk Editors: Aanand Jayaraman/Shreya Gopi Typeset by Stallion Press Email: enquiries@stallionpress.com Printed in Singapore Aanand Jayaraman - 11057 - A Practical Approach to XVA.indd 02-05-19 1:55:21 PM May 7, 2019 14:16 A Practical Approach to XVA: The Evolution - 9in x 6in To Maika v b3488-fm page v b2530   International Strategic Relations and China’s National Security: World at the Crossroads This page intentionally left blank b2530_FM.indd 01-Sep-16 11:03:06 AM May 7, 2019 14:16 A Practical Approach to XVA: The Evolution - 9in x 6in b3488-fm Foreword If all that interests you about finance are the latest trends — machine learning, fintech, algo trading, quantum computing — then look elsewhere But there is so much more to financial markets — aren’t you curious what happened to the derivatives market with notionals in trillions prior to the financial crisis of 2008? In fact, they have not gone away — of course some of the more esoteric products (like CDO squared) have fallen out of favor But vanilla derivatives like swaps are still very much in demand The only thing is that, these days there is rightly far greater consciousness of the costs of doing business — including the average cost of counterparty default, the cost of funding the position, the cost of margin, and the cost of capital This then is the subject matter of this book — the various adjustments (Cross-Valuation Adjustments or XVA) that fully reflect the cost of dealing in derivatives There was always a need to bridge academia and industry For example, information about efficient markets was taught heavily in universities, notwithstanding various examples of market dislocation (e.g the 1987 stock market crash) So it is worth considering the framework of derivatives valuation with the same amount of cynicism Simply put, derivatives valuation is based on the cost of constructing a portfolio (possibly dynamically rebalanced) so that it attains the same payoff as the derivative of interest at a future time under any realized market condition — the cost of vii page vii May 7, 2019 viii 14:16 A Practical Approach to XVA: The Evolution - 9in x 6in b3488-fm Foreword constructing this portfolio then gives the value of the derivative (The ability to replicate the payoff removes the need to take account of the true dynamics of the underlying, and this is not premised on rational investors but the existence of liquid markets to execute the transactions necessary to attain the payoff of the derivative.) Regardless of whether one believes in the ability to replicate the payoff perfectly, there are various externalities not well accounted for by this replication approach in the environment post the 2008 financial crisis Firstly, the counterparty with which one transacts can default, and if so, the payoff will not be realized This externality can be incorporated in the valuation by augmenting the payoff to take account of default, and hedging for default via Credit Default Swaps can be undertaken to lock in the cost — this is Credit Valuation Adjustment (or CVA) In a similar vein, with a clear recognition of the fallibility of financial institutions during the 2008 crisis, an institution is not default-free and if its default is to be taken into account, we get Debt Valuation Adjustment (or DVA) This adjustment may be demanded by large corporates (with strong bargaining power) against which a financial institution is attempting to trade But this is just the beginning — to replicate a payoff often involves executing transactions in the derivatives or cash market and this must be funded if there is a need to purchase the underlying Whereas prior to 2008, it was assumed (somewhat justifiably then but no longer so) that AA financial institutions can fund their positions at Libor (i.e borrow or lend at the same rate), so the theoretical risk-free rate used for derivatives valuation can simply be replaced by the Libor rate and there is no more need to worry about funding costs But this is no longer true, with banks funding at Overnight Index Swap (OIS) for collateralized positions and Libor potentially being phased out The forward OIS curve happens to be lower than the government curve even for major developed economies (like USA or Germany), so funding a position (to lend to someone else) now has a cost — not just about credit but an institution’s own page viii May 7, 2019 14:16 A Practical Approach to XVA: The Evolution - 9in x 6in Foreword b3488-fm page ix ix cost of borrowing This is a real controversial area since it breaks the law of one price — different institutions have different funding costs But reality does not have to be elegant — would you lend below your cost of borrowing, just because other institutions would lend at a lower rate? If that were not enough, the crisis of 2008 has led to regulators seeking to reduce counterparty risk by requiring more derivatives to be cleared on exchanges — i.e where the exchange (that is backed by initial margin requirements for derivatives, reserve funds and guarantees of clearing members) would be party to both sides of the deal Or for positions that are not exchange cleared, there is the requirement for both parties to post initial margin to an independent third party to guarantee performance All well and good to reduce counterparty risk But the initial margin imposes a huge business cost, i.e Margin Valuation Adjustment (or MVA) Finally, regulators have belatedly raised capital requirements massively post 2008 to ensure financial institutions have enough buffer to deal with losses from market risk or counterparty credit risk — this comes in the form of additional components of riskweighted assets (e.g stress Value-at-Risk or CVA Value-at-Risk or Incremental Risk Charge), as well as in the form of requirements for higher capital requirements as a percentage of risk-weighted assets This has severe implications on the long-dated uncollateralized client business, e.g long-dated cross-currency swaps (typically 30 years) and inflation zero swaps (up to 50 years in UK) There have been product innovations like the advent of mark-to-market cross-currency swaps, or a decline in business for other products (e.g inflation zero swaps) We can compute the capital implications in an ad hoc manner — after all, is it really P&L? But it is a key driver of business decision, and may be best recognized as such This is Capital Valuation Adjustment (or KVA) With the above myriad of valuation adjustments, we just need someone to explain what they are and how to go about computing them in a practical way — there are authors who have been carried away with enthusiasm and come up with grandiose frameworks where ... Finance Manager at a Leading Global Bank page x May 7, 2019 14:16 A Practical Approach to XVA: The Evolution - 9in x 6in b3488-fm Preface After the 2008 financial crisis, derivatives valuation. .. sophisticated as risk-free valuation On the other hand, for the FVA and MVA, the valuations are important because these are 287 page 287 May 7, 2019 14:16 A Practical Approach to XVA: The Evolution. . .A PRACTICAL APPROACH TO The Evolution of Derivatives Valuation after the Financial Crisis 11057_9789813272736_TP.indd 7/5/19 9:41 AM b2530   International Strategic Relations and China’s National