Trésorier/Treasurer magazine - N°84 - Jan/Feb/Mar 2014 - (Page 43)

CORPORATE FINANCE Protecting your company against counterparty risk - Credit Value Adjustment and the new regulatory reality Levels of implementation and readiness for the transition to CVA-based credit protection vary widely. The greatest level of CVA implementation is in interest rates. It is currently being phased in for other asset classes; in fact, CVA measurement for standard corporate hedging instruments for FX and commodities is already becoming fairly widespread. CVA calculation for a single trade CVA is a probabilistic calculation of expected losses due to the potential for counterparty default on a trade or a portfolio of trades. First, consider the calculation of CVA for a particular point in time between now and the final maturity date of a specific trade. The calculation for trades with no collateralisation for time t is: CVA(t) = DefaultProbability(t) * ExpectedLoss(t) * (1 - RecoveryRate). Where: - DefaultProbability(t) = the probability of the counterparty defaulting at or before time t, based on the counterparty's CDS curve - RecoveryRate = the expected recovery rate for senior creditors in the event of default - ExpectedLoss(t) = The expectation of positive MTM as of time t i.e. integration over the positive MTM portion of the implied distribution To put this in simple terms, the following two questions are answered: 1.What is the likelihood of the counterparty defaulting? 2. If the counterparty defaults, how much money will be lost? For trades which fall under a CSA with a non-zero threshold, the calculation will be: CVA(t) = DefaultProbability(t) * min[ExpectedLoss(t) * (1 - RecoveryRate),Threshold] Where: Threshold = the collateralisation threshold specified in the CSA. Default probability is derived using the market standard calculation based on the counterparty's CDS. This provides a good measure of the CVA for one particular point in time t. Realistically, the counterparty may default at any time during the life of the trade. In order to get the true measure of credit risk, one must look at the default over the entire life of the trade. This is done using a "lifetime expectation" calculation. This essentially means dividing the time between today and the final maturity of the trade into a set of time LE MAGAZINE DU TRESORIER / TREASURER MAGAZINE - N°84 - JAN CVA is a critical component of derivative pricing, particularly for uncollateralised trades, allowing the adjustment of both mark-to-market valuations as well as new trade pricing. With the end of year reporting requirements for IFRS 13 regulations approaching, many treasurers are struggling to meet the compliance deadline and fully understand the new standards. The complexities are increased when considering that the new rules have to co-exist with the detailed accounting regulations that are in place already, such as the those outlined in the FAS statements and International Accounting Standard (IAS). As a result, treasurers require adequate technology that will be able to run a number of fast and robust algorithms. Each asset class or even instrument type has its own specifics, and may need its own algorithm, and the design of these algorithms requires significant mathematical and market expertise and experience. / FEV / MAR 2014 The importance of quantifying and managing counterparty credit risk in the derivatives market has never been greater. One of the most important effects of the economic crisis on OTC derivatives markets has been greater attention to and valuation of the credit risk inherent in any derivatives trade. Accurate Credit Valuation Adjustment (CVA) requires significant expertise and sophisticated technology. How can treasurers equip themselves with the tools they need to stay afloat in today's uncertain market conditions? 43

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INTERVIEW Martin Sadleder- Treamo Business Consulting

Trésorier/Treasurer magazine - N°84 - Jan/Feb/Mar 2014