Cva Proxy Spreading

Cva Proxy Spreading

Banks say Europe’s CVA proxy-spread plans lack flexibility

Dealers welcome EBA proposals but say limited number of eligible counterparties means few benefits
The European Banking Authority recommends that firms should use alternative approaches based on a more fundamental analysis of credit risk

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Dealers have welcomed new European proposals to provide flexibility in the calculation of derivatives counterparty risk capital requirements for hard-to-measure clients, but they say the rules are too restrictive to be of significant benefit.
In June, the European Banking Authority (EBA) proposed amendments to the method for calculating the Basel III credit valuation adjustment (CVA) risk charge for counterparties with illiquid or no credit default swaps (CDSs) of their own, and where no proxy
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Home › Resources › Knowledge › Trading & Investing › Credit Valuation Adjustment (CVA)
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The price that an investor would pay to hedge the counterparty credit risk of a derivative instrument
Credit Valuation Adjustment (CVA) is the price that an investor would pay to hedge the counterparty credit risk of a derivative instrument . It reduces the mark to market value of an asset by the value of the CVA.
Credit Valuation Adjustment was introduced as a new requirement for fair value accounting during the 2007/08 Global Financial Crisis . Since its introduction, it has attracted dozens of derivatives market participants, and most of them have incorporated CVA in deal pricing.
The formula for calculating CVA is written as follows:
The concept of credit risk management, which includes credit valuation adjustment, was developed due to the increased number of country and corporate defaults and financial fallouts . In recent times, there have been cases of sovereign entity defaults, such as Argentina (2001) and Russia (1998). At the same time, a high number of large companies collapsed before, during, and after the financial crisis of 2007/08, including WorldCom, Lehman Brothers, and Enron.
Initially, research in credit risk focused on the identification of such a risk. Specifically, the focus was on counterparty credit risk, which refers to the risk that a counterparty may default on its financial obligations.
Prior to the 2008 financial crisis, market participants treated large derivative counterparties as too big to fail and, therefore, never considered their counterparty credit risk. The risk was often ignored due to the high credit rating of counterparties and the small size of derivative exposures. The assumption was that the counterparties could not default on their financial obligations like other parties.
However, during the 2008 financial crisis, the market experienced dozens of corporate collapses, including large derivative counterparties. As a result, market participants started incorporating credit valuation adjustment when calculating the value of over-the-counter derivative instruments.
Derivative instruments can be classified as either unilateral or bilateral, depending on the nature of the payoff.
For a unilateral derivative instrument holder, exposure to loss occurs if a counterparty defaults on their financial obligations. The amount of loss that an investor incurs is equal to the fair value of the instrument at the time of default.
Bilateral derivatives are more complex than unilateral derivatives, since the former includes two-way counterparty risk. This means that both the counterparty and the investor are exposed to counterparty risk. The advantage of bilateral derivatives is that the derivative may adopt an asset or liability position at any valuation date.
For example, if Counterparty A is at a positive asset position today, it is exposed to Counterparty B. If A defaults on his obligation, he will owe the positive asset to B. The same applies if B is in a negative liability position because, in case of default, he owes the negative liability position to A.
There are several methods that are used to value derivatives, and they vary from simple to advanced methodologies. Determining the credit valuation adjustment method to use depends on the organization’s sophistication and resources available to the market participants.
The simple method calculates the mark to market value of the instrument. The calculation is then repeated to adjust the discount rates by the counterparty’s credit spread. Calculate the difference between the two resulting values to obtain the credit valuation adjustment.
The swaption-type is a more complex credit valuation adjustment methodology that requires advanced knowledge of derivative valuations and access to specific market data. It uses the counterparty credit spread to estimate the replacement value of the asset.
This involves the simulation of market risk factors and risk factor scenarios. The derivatives are then revalued using multiple simulation scenarios. The expected exposure profile of each counterparty is determined by aggregating the resulting matrix. Each counterparty’s expected exposure profile is adjusted to derive the collateralized expected exposure profile.
Thank you for reading CFI’s guide on Credit Valuation Adjustment (CVA). To keep learning and advancing your career, the following resources will be helpful:

14 December 2017
Gavan Nolan

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To stay on top of the mountain of regulation emanating from the various authorities can feel like a Sisyphean task. So one could be forgiven for overlooking a consultation launched by the European Banking Authority in July 2016 (one of 35 that year) that resulted in final draft Regulatory Technical Standards (RTS) published in June 2017.
Nonetheless, institutions calculating Credit Valuation Adjustment (CVA) should pay heed to the EBA's document. The consultation addressed an important issue, namely the use of proxy spreads in CVA. Single name CDS spreads are explicitly required - under Article 383 of the Capital Requirements Regulation - as part of the calculation for own funds requirements for CVA risk. But if single names spreads are not observable for certain counterparties a proxy spread should be used. EU regulations (CRR) in 2013 and 2014 established the three-factor approach - rating, industry and region - to determine proxy spreads.
Sector curves (e.g. a Europe BB Financials curve) are now widely used as proxies in CVA processes. This works well for the vast majority of counterparties. But the EBA's consultation and subsequent RTS addressed the possibility of using alternative approaches based on fundamental analysis of credit risk to proxy the spreads. In particular, this method may be applicable for counterparties that not only they, but also their peers, have no observable CDS spreads.
The EBA's RTS introduces some welcome flexibility to determining proxy spreads. New language was added that allows the use of alternative measures of credit risk, which is likely to include fundamental analysis. Institutions will have to provide a rationale and document the methodology.
However, there are important caveats. Alternative proxy approaches can only be used when CDS spreads or "spreads of other liquid credit risk instruments" are unavailable for the counterparty's peers, i.e. entities that share the same rating, industry and region characteristics. This means that even if CDS spreads are unavailable, the far larger bond universe would first have to be utilized before alternative methods can be implemented. This limits the ability of banks to deviate from the three-factor model and is likely to restrict alternative methods to sectors such as project finance and infrastructure.
In short, the RTS consolidates the use of sector curves as proxy spreads, along with some new, restricted provisions to use fundamental analysis where credit data is lacking. The EBA's summary of responses to the consultation and their analysis also contains important clarifications to the regulation. One respondent suggests a hierarchy should be introduced consisting of: (i) single name CDS; (ii) bond spreads; (iii) CDS sector proxy spread; (iv) bond sector proxy spread; (v) alternative approach based on fundamentals. The EBA's response was illuminating. It reaffirmed that proxy spreads can reflect "other liquid traded credit risk instruments", as well as CDS spreads. This gives the green light to use bond sectors as proxies, which wasn't always clear to many European institutions.
The RTS also provides additional flexibility in using the spread of a parent entity as a proxy for a subsidiary - important for overseas subsidiaries that were previously allocated misleading sector curves as proxies - as well as amendments to the Loss Given Default formula in CVA. But the main thrust of the RTS is that the three-factor approach to determining proxy spreads is here to stay. It follows that sourcing accurate sector curves - both CDS and bonds - remains as important as ever. Indeed, the EBA estimates that proxy spreads are applied for 77% of counterparties. Banks should ensure that sector curves are derived from datasets that are both accurate and extensive, as well as using a methodology that is robust and transparent.
Gavan Nolan, Director, Fixed Income Pricing, IHS Markit
Tel: +44 20 7260 2232

gavan.nolan@ihsmarkit.com
IHS Markit provides industry-leading data , software and technology platforms and managed services to tackle some of the most difficult challenges in financial markets. We help our customers better understand complicated markets, reduce risk, operate more efficiently and comply with financial regulation.
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