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World Bank Group
Valuation Issues in Today’s
Marketplace
May 20, 2015
Presentation Topics
Contents
1
Fair Value and Associated Adjustments
2
Credit Valuation Adjustments (CVA) / Debit/Debt Valuation Adjustments (DVA)
3
Funding Valuation Adjustments (FVA)
4
XVA
5
Curve Construction
6
MTM Swaps
7
Islamic Finance
8
Catastrophe Bonds
World Bank Presentation, May 20, 2015
Fair Value
Definition and Various Adjustments
1. Fair Value
Definition of Fair Value
2. CVA/DVA
FAS 157 defines fair value as:
-
Definitions and Key
Drivers
-
Calculation
Methodologies and
Implementation
-
The price that would be received to sell an asset or paid to transfer a liability in an orderly
transaction between market participants at the measurement date.
World’s Bank Current
Situation
3. FVA
Adjustments to Base Mark-to-Market Valuation of Derivatives
FAS 157 indicates that fair value should include nonperformance risk. As derivatives are
commonly modeled under a risk neutral framework, a Credit Valuation Adjustment (CVA) to
risk-neutral MTM becomes necessary to be fair value compliant for uncollateralized or partially
collateralized positions.
4. XVA
5. Curve Construction
6. MTM Swaps
7. Islamic Finance
The type of credit valuation adjustment that reflects the counterparty default risk is referred to as
Counterparty Valuation Adjustment, also known as CVA. The type of credit valuation
adjustment that reflects the entity’s own non-performing risk is referred to as Debt Valuation
Adjustment (DVA).
8. Catastrophe Bonds
CVA and DVA may be combined into a single bilateral number used to reflect the bilateral credit
valuation adjustment that captures both a counterparty’s and entity’s own non-performing risks.
Funding Valuation Adjustment (FVA) is a non-credit valuation adjustment. It captures the
funding difference between collateralized and uncollateralized derivatives positions. FVA is a
relatively new phenomenon tied to the credit crisis and its aftermath regulatory reforms especially
the push for central counterparty (CCP) clearing for derivatives and collateralization for non CCP
cleared derivatives.
World Bank Presentation, May 20, 2015
Fair Value
Definition and Various Adjustments
1. Fair Value
2. CVA/DVA
-
Definitions and Key
Drivers
-
Calculation
Fully Collateralized Derivatives
Fully collateralized derivatives either by ISDA agreements or through cleared by CCP
assume zero CVA or DVA.
Fair value calculation for fully collateralized derivatives is performed using overnight index
swap (OIS) discounting.
Methodologies and
Implementation
-
World’s Bank Current
Partially Collateralized Derivatives
Situation
Non-zero collateral posting threshold and non-zero minimal collateral posting amount
cause partial collateralization of derivatives. CVA/DVA for partially collateralized derivatives
is typically performed by assuming CVA/DVA for the collateralized portion of the position to
be zero, while calculating CVA/DVA for the uncollateralized portion.
3. FVA
4. XVA
5. Curve Construction
6. MTM Swaps
7. Islamic Finance
8. Catastrophe Bonds
If OIS is used for discounting, FVA is often calculated to account for the difference between
OIS and the funding cost for uncollateralized portion.
World Bank Presentation, May 20, 2015
Credit Valuation Adjustments (CVA) and Debit/Debt Valuation Adjustments (DVA)
CVA - Definition and Key Drivers
1. Fair Value
2. CVA/DVA
-
Definitions and Key
Drivers
-
Definition
CVA represents the risk to an entity that its counterparty will not be able to fulfill its end of a
derivative transaction. CVA quantifies expected losses due to its counterparty’s default, and
because of this, CVA brings down the value of an entity’s derivative assets.
Calculation
Methodologies and
Implementation
Key Drivers
3. FVA
Like other expected loss calculations, CVA is an exposure * probability of default * loss
given default calculation. CVA increases when each of the following increases for a given
position, or portfolio of positions:
4. XVA
• Counterparty credit spreads
5. Curve Construction
• Loss given default (loss severity)
6. MTM Swaps
• Time to maturity
7. Islamic Finance
• Expected positive future exposures to the counterparty
-
World’s Bank Current
Situation
8. Catastrophe Bonds
We note the following:
• PD is usually a positively sloped term structure and therefore long-date expected future
exposures have more impact on CVA
• Loss given default (LGD) is calculated as 1 – recovery and often treated as a constant.
• As a first order approximation, credit spread can be considered as the product of PD *
LGD. For an entity, the higher the seniority on the capital structure, the lower the credit
spread for the liability is. For example, a secured loan margin is usually lower than an
unsecured bond spread.
World Bank Presentation, May 20, 2015
Credit Valuation Adjustments (CVA) and Debit/Debt Valuation Adjustments (DVA)
DVA - Definition and Key Drivers
1. Fair Value
2. CVA/DVA
-
Definitions and Key
Drivers
-
Definition
DVA measures the risk to that entity’s counterparties from its own credit and represents the
risk to an entity’s counterparties that it will not be able to fulfill its end of a derivative
transaction. As a result, DVA brings down the value of an entity’s liabilities.
Calculation
Methodologies and
Implementation
Key Drivers
3. FVA
Like CVA, DVA is also an exposure * probability of default * loss given default calculation.
DVA increases when each of the following increases for a given position, or portfolio of
positions:
4. XVA
• Own credit spreads
5. Curve Construction
• LGD
6. MTM Swaps
• Time to maturity
7. Islamic Finance
• Expected negative future exposures to the counterparty
-
World’s Bank Current
Situation
8. Catastrophe Bonds
World Bank Presentation, May 20, 2015
Credit Valuation Adjustments (CVA) and Debit/Debt Valuation Adjustments (DVA)
Calculation Methodologies and Implementation
1. Fair Value
2. CVA/DVA
-
Definitions and Key
Drivers
-
Calculation
Methodologies and
Implementation
-
World’s Bank Current
Situation
Calculation Methodologies – Analytical Formulas versus Monte Carlo Simulation
In some cases, CVA/DVA for individual positions may be calculated using analytical
formulas where there are closed-form solutions to determining expected future exposures.
However, there are many derivatives where analytical formulas cannot be used and the
projection of future exposures cannot be done so easily. For this reason (among others),
many larger banking organizations, including all of the largest money center banks,
calculate CVA/DVA using Monte Carlo simulation to project future exposures, and then
apply probabilities of default and recovery rate assumptions to calculate expected
nonperformance risk.
3. FVA
4. XVA
Individual Position-level versus Portfolio-level calculations
5. Curve Construction
6. MTM Swaps
7. Islamic Finance
8. Catastrophe Bonds
CVA/DVA may be calculated for individual positions or on a counterparty portfolio-level.
Portfolio-level CVA/DVA is often preferred or even required by netting agreements.
Portfolio-level CVA/DVA calculations essentially require that a Monte Carlo simulation
methodology be used in order to capture all of the correlated movements in market data
that drive derivative valuations.
As CVA/DVA is not additive, it can be difficult to allocate portfolio-level CVA/DVA to
individual positions. The marginal CVA/DVA approach (computing the net CVA/DVA of a
portfolio with an without that position) may be most accurate but can be time consuming.
World Bank Presentation, May 20, 2015
Credit Valuation Adjustments (CVA) and Debit/Debt Valuation Adjustments (DVA)
Calculation Methodologies and Implementation (continued)
1. Fair Value
2. CVA/DVA
-
Definitions and Key
Drivers
-
Calculation
Methodologies and
Implementation
-
World’s Bank Current
Situation
3. FVA
4. XVA
5. Curve Construction
6. MTM Swaps
7. Islamic Finance
8. Catastrophe Bonds
Netting CVA and DVA Together – What to Expect and What Could Happen
Between two parties of roughly equal creditworthiness, netting the two together typically
results in a valuation that is smaller in absolute value; assets would become smaller in
size, as would liabilities.
In some cases, however, calculating and applying CVA/DVA may result in an asset that
turns into a liability, or vice versa. While counterintuitive, these situations are more likely to
occur when:
• There is a large discrepancy in credit spreads between the parties involved
• The mark-to-market value before adjustment of the position is relatively small and
projected to flip from an asset to liability, or vice versa
• There is a long time to maturity
A large discrepancy in credit spreads could mean that even if the potential future exposures
are projected to remain relatively stable over time, the calculated CVA (or DVA) may
outweigh the other due solely to the large difference in default probabilities. The last two
reflect the possibility that the exposure itself may change over time, so even if you were to
exclude CVA and DVA altogether, the position may be expected to flip to begin with, making
an initially unexpected CVA/DVA calculation more understandable.
World Bank Presentation, May 20, 2015
Credit Valuation Adjustments (CVA) and Debit/Debt Valuation Adjustments (DVA)
World Bank’s Current Situation
1. Fair Value
2. CVA/DVA
-
Definitions and Key
Drivers
-
Calculation
Methodologies and
Implementation
-
World’s Bank Current
Situation
3. FVA
4. XVA
Implications for World Bank
The World Bank Group has ISDA (International Swaps and Derivatives Association)
agreements with all of its counterparties that require its counterparties to post collateral to
the World Bank in the event a derivative becomes a liability to them (and an asset to the
World Bank). These agreements also require that the World Bank post collateral in the
event that World Bank’s credit rating falls below AAA, which means that no collateral is
being posted on the part of the World Bank right now.
What this means is that World Bank is not exposed to the nonperformance risk of its
counterparties (CVA is zero) because collateral is being posted. The DVA for World Bank
is also zero because its AAA rating means the market thinks the market-perceived
probability of World Bank defaulting is close to zero.
5. Curve Construction
6. MTM Swaps
OIS or LIBOR Discounting?
7. Islamic Finance
Because of the one-way collateralization, neither OIS discounting nor LIBOR discounting is
perfect for World Bank’s derivatives valuation. Using OIS for discounting and then applying
a liability FVA (LFVA) to capture funding difference for WB’s liability discounting is one of
the acceptable approaches.
8. Catastrophe Bonds
World Bank Presentation, May 20, 2015
Funding Valuation Adjustments (FVA)
Definition and Controversy
1. Fair Value
2. CVA/DVA
3. FVA
4. XVA
5. Curve Construction
Definition
FVA is a post-crisis phenomenon after the 2008 credit crisis as more derivatives are either
collateralized or cleared by CCPs. It is used to reflect the impact of additional funding cost over
OIS on the valuation of uncollateralized derivatives positions. FVA becomes significant for broker
dealers when they enter transactions in a retail market where a substantial portion of derivatives
positions is uncollateralized and then hedge them in a broker dealer market where almost all
derivatives transactions are collateralized.
6. MTM Swaps
7. Islamic Finance
8. Catastrophe Bonds
How it Works
FVA is similar to CVA and DVA in that its magnitude depends on the size of expected
uncollateralized future exposures. For that reason, large financial institutions have built their FVA
calculation based upon their CVA framework for expected future exposures calculation.
Essentially, the only additional critical model input for FVA is the funding spread over OIS.
Market Approach vs. Entity Specific Approach
FVA using an entity’s own funding is more accurate and easier to be hedged while FVA using a
market average funding cost has the backing of the fair value accounting guidelines, which says
the fair value of a derivative is not entity specific but the exit price accepted by general market
participants.
Many large US money center banks have adopted the market approach by estimating funding
spread from the market consensus provided by Markit. We note that using the spread of LIBOR
over OIS for FVA calculation assumes LIBOR to be the market average funding for
uncollateralized positions.
World Bank Presentation, May 20, 2015
Funding Valuation Adjustments (FVA)
Definition and Controversy (continued)
1. Fair Value
2. CVA/DVA
3. FVA
4. XVA
5. Curve Construction
6. MTM Swaps
Symmetric vs. Asymmetric Funding Costs
Some large banks consider funding costs to be asymmetric with respect to assets and
liabilities. The evidence for such an approach is about half of Totem’s participants quote
asymmetric FVA. You may also find support for the argument in accounting rules – asset
valuation requires marking to exit prices while liability valuation requires assuming a
hypothetical transfer to a 3rd party of equal credit standing.
Using LIBOR-OIS spread for FVA calculation assumes funding cost is symmetric.
7. Islamic Finance
8. Catastrophe Bonds
Netting Considerations
Two levels of netting need to be considered – counterparty level and funding desk level. As
default of a counterparty will cause termination of existing positions with that counterparty
and therefore eliminate the need to fund these positions, expected future exposures for
FVA are calculated contingent on the survival of the counterparty, similar to CVA/DVA
calculation. In other words, certain aspects of expected future exposure calculation for FVA
need to be done at counterparty level. That is the reason why FVA calculation often
leverages the infrastructure constructed for CVA/DVA calculation.
However, funding is also affected by the netting at the entire funding desk level provided
rehypothecation is allowed. That means across counterparty netting is sometimes
necessary for FVA calculation.
If a symmetric funding cost is taken, e.g. LIBOR-OIS spread is used for both asset and
liability FVA calculation, netting at any level is trivial. However, that’s not the case for any
asymmetric approaches.
World Bank Presentation, May 20, 2015
Catch-All Valuation Adjustments (XVA)
XVA – and Basel Steps in
1. Fair Value
2. CVA/DVA
3. FVA
Operational Inefficiencies and Creation of the XVA Desk
Many organizations have created an XVA Desk to allow an entity to price a derivative in
real time with all of these adjustments at once through one centralized desk.
4. XVA
5. Curve Construction
6. MTM Swaps
Credit Valuation
Adjustment (CVA) Desk
Debt/Debit Valuation
Adjustment (DVA) Desk
Funding Valuation
Adjustment (DVA) Desk
Various Other
Adjustments
7. Islamic Finance
8. Catastrophe Bonds
XVA Desk
Uncertain Outcome
On 3/20/2015, the Basel Committee on Banking Supervision launched a project reviewing
FVA at various banks – and so have US bank supervisors. Given that more than 20 banks
have begun to implement FVA, with varying methodologies, losses have ranged wildly
($1.5 billion at JPMorgan, 267 Swiss Francs at UBS).
While it’s not certain what the scope of this project will entail, market participants do not
expect regulators to speak about FVA specifically but may provide guidance on the
relationship between FVA and DVA, as the two capture similar risks.
World Bank Presentation, May 20, 2015
Multi-Curve Construction
Shift from Single to Dual Curve Bootstrapping
1. Fair Value
2. CVA/DVA
3. FVA
4. XVA
5. Curve Construction
6. MTM Swaps
7. Islamic Finance
8. Catastrophe Bonds
Rise of OIS Discounting and Impact
The increase in the number of collateralized derivatives trades after the credit crisis and
shift to OIS discounting for those deals forced a change in the manner in which LIBOR
rates are quoted. For collateralized positions, whereas LIBOR is still used for cashflow
projection, OIS is used for discounting the cash flows.
Changes in Curve Construction – Single and Dual Curve
Previous curve construction methodologies were “single curve” methodologies, which were
not only general market practice, but also very computationally quick.
Current curve construction methodologies call for a “dual curve” model, where OIS and
LIBOR curves are generated simultaneously. Various steps can be taken as part of this
curve construction process, with a tradeoff between accuracy and computational time. In a
dual curve methodology, the following steps are generally taken:
• Bootstrap OIS curve instruments to generate OIS discount factors
• Use LIBOR instruments and OIS discount factors to bootstrap LIBOR curve
• Bootstrap OIS again using the generated forward LIBOR curve
• Repeat until the desired level of tolerance is reached
• Use this forward LIBOR curve to generate other LIBOR tenor and cross-currency basis-
adjusted curves
Another popular alternative is global bootstrapping, a computational method used to
generate both curves at once with the goal of optimizing the fit of both curves to the market
data provided though this method is computationally expensive, with other various
methodologies used to try to optimize the tradeoff between accuracy and speed.
World Bank Presentation, May 20, 2015
Mark-to-Market (MTM) Cross Currency Swaps
Variant of Typical Cross Currency Swaps
1. Fair Value
2. CVA/DVA
3. FVA
Typical Cross Currency Swaps
Most cross currency swaps are traded with a fixed notional. This can cause significant FX risk,
as changes in FX rates between the time a swap is entered into and the final notional exchange
can cause significant gains and losses and drive most of the value of these types of positions.
4. XVA
5. Curve Construction
6. MTM Swaps
7. Islamic Finance
8. Catastrophe Bonds
Mark-to-Market (MTM) Cross Currency Swaps
This significant FX risk has given rise to a new form of cross currency swaps, referred to MTM
swaps or resetting swaps. In these positions, the notional on one side is fixed, while the notional
on the other leg varies periodically, typically resetting with each payment period.
A typical example would be a EUR/USD cross-currency swap in which the EUR leg is fixed at a
pre-specified notional amount (i.e. 100 million EUR) and pays a floating rate (i.e. 3M EURIBOR).
The USD leg would have an initial notional amount based on the FX rate at the time the swap
was entered into (i.e. 1.25) and pay 3M LIBOR, with its notional amount resetting based on the
observed EUR/USD FX rate at the time of each payment.
These notional resets would trigger a principal exchange equal to the difference in the new
principal amount and the then-current principal amount, but would also reduce the impact of the
final principal exchange at maturity as well.
Date
EUR Notional
FX Rate
USD Notional
USD Notional (Paid)/Received
by USD Leg
12/31/2014
EUR 100MM
1.25
USD 125MM
3/31/2015
EUR 100MM
1.20
USD 120MM
(5MM)
6/30/2015
EUR 100MM
1.30
USD 130MM
10MM
World Bank Presentation, May 20, 2015
Islamic Finance
Principles and Products
1. Fair Value
2. CVA/DVA
3. FVA
4. XVA
5. Curve Construction
6. MTM Swaps
7. Islamic Finance
8. Catastrophe Bonds
Rise of the Industry
Islamic banking is a subset of banking activities that is meant to be in compliance with
sharia, or Islamic law. While sharia has been codified for some time, the development of
Islamic banking practices and principles did not begin to develop until relatively recently;
though since its development, growth has been tremendous. Per Ernst & Young, Islamic
banking assets have grown at an annual rate of 17.5% between 2009 and 2013, and are
expected to grow an average of 19.7% a year through 2018.
This growth is not due entirely to a growth in Islamic investors trying to adhere to sharia,
but also value investors looking for a good deal.
Principles behind Islamic Finance Products
Sharia prohibits the following activities:
• Usury - payment or charging of interest
• Maysir – speculation
• Investment in activities deemed sinful under Islamic law (alcohol, pork, gambling)
World Bank Presentation, May 20, 2015
Islamic Finance
Principles and Products (continued)
1. Fair Value
2. CVA/DVA
3. FVA
4. XVA
5. Curve Construction
6. MTM Swaps
7. Islamic Finance
8. Catastrophe Bonds
Examples of Products
In practice, these prohibitions mean that workarounds are made to achieve compliance
with sharia, though they may seem obtuse at first.
Because sharia prohibits the payment or charging of interest, Islamic mortgages are
structured differently from a typical mortgage. Instead, a bank may buy a home from its
seller directly, and then resell the home back to the original intended buyer at a profit,
allowing the buyer to make those above-market rate payments, nominally all principal, in
installments that would be equal to the payments due under a more typical mortgage.
A sukuk, or Islamic bond, does not pay interest per se. Instead, the buyer owns a nominal
share of whatever the money raised from issuing the sukuk purchased, and receives
money derived from the profit generated from that asset or from rental payments made by
the issuer to compensate the buyer for its use. Functionally, however, these payments are
typically structured such that they are no different from a fixed or floating rate bond.
In addition, the prohibition on speculation generally rules out derivatives, options and
futures, because they do not represent an investment in their underlying assets and are
considered to be speculative gambles on their movements. As a result, many banks
adhering to sharia withstood the credit crisis better than their less pious counterparts
because of their relatively smaller derivative exposures.
World Bank Presentation, May 20, 2015
Catastrophe Bonds
Market and Motivation
1. Fair Value
2. CVA/DVA
3. FVA
4. XVA
5. Curve Construction
6. MTM Swaps
7. Islamic Finance
8. Catastrophe Bonds
Definition
Catastrophe bonds (also commonly called cat bonds) are a specific type of bond, typically
used by insurance companies, to transfer the risk of catastrophic events (hence the name)
insured by the issuing companies.
As an example, a catastrophe bond may pay a specified coupon to the holder, but if the
specific event type named (i.e. hurricane or earthquake) in the bond occurs, the issuer
would keep some or all of the principal invested and not be required to repay that to their
investors. These bonds are usually issued by special purpose vehicles which are then cash
collateralized; therefore, the risk of principal default is not the risk that the issuer will
default, but that a catastrophic event will occur during the lifespan of the bond – usually
around or less than three years.
Motivations for the Broad Insurance Market
Cat bonds were created in response to Hurricane Andrew, which took place in 1992. The
motivation for the market at large was to share insurance risk among more possible
participants, as catastrophe reinsurers began to become reluctant to bear too much
reinsurance risk:
World Bank Presentation, May 20, 2015
Catastrophe Bonds
Market and Motivation (continued)
1. Fair Value
Motivations for Individual Issuers and Investors
2. CVA/DVA
The motivation for individual issues were numerous as well:
3. FVA
• The ability to achieve a fixed price for reinsurance over a potentially longer time frame
4. XVA
• Potentially lower cost of reinsurance
5. Curve Construction
• Quicker payouts in the event of catastrophic events by being able to keep principal
6. MTM Swaps
7. Islamic Finance
8. Catastrophe Bonds
already invested rather than waiting for reinsurance payouts
• Off-balance sheet SPV provide benefits with respect to capital requirements and help
with issuer credit risk
The motivation for investors such as hedge funds, pension funds, asset managers, and
other large institutional investors include high coupons (ranging from 3-20% over LIBOR
depending upon the risk), and the fact that their value is usually uncorrelated to other more
standard investments in fixed income and equities. While this makes hedging these
instruments difficult, the added diversification is often considered to outweigh that risk.
World Bank Presentation, May 20, 2015