style="font-size:15px;"> CCP variation margin arrangements are very similar to a strong CSA with a daily call frequency and in some circumstances collateral can be called intraday. Given the presence of initial margin the residual expected exposure to the derivative trades themselves will be very small or zero.8 However, there remains the possibility of exposure to the CCP itself through the initial margin and the default fund. If the initial margin is bankruptcy remote then the exposure generated by posted initial margin can be excluded from CVA. However, this is not the case for the default fund contributions which are designed to be used in the event of the default of a member. The default fund certainly generates exposure and hence credit risk.
1.3.5 FVA
FVA was initially controversial in the quantitative finance community as is clear from the series of papers by John Hull and Alan White (2012b; 2012c; 2014b) and the responses to them by Castagna (2012), Laughton and Vaisbrot (2012), Morini (2012) and Kenyon and Green (2014c). The debate around FVA is discussed in section 1.4.1 and FVA models are presented in Part II; however, it is clear that most market practitioners believe a pricing adjustment should be made for the cost of funding unsecured derivative transactions. In this context FVA represents the costs and benefits from managing the collateral on hedges used to eliminate market risk from the unsecured transactions. FVA and CVA together can be viewed as the cost of not trading under a perfect CSA agreement. The accounting status of FVA is now in transition with increasing numbers of banks taking reserves.
Unsecured
As with CVA, unsecured trades are the standard case for FVA as both counterparties are fully exposed to each other. Symmetric models with both funding cost and benefits as well as asymmetric models with only funding costs have been proposed with a key determining factor being the potential overlap with DVA benefit. Broadly speaking, methodologies for FVA are either based on discounting, as noted earlier, or on exposure-based models that are extensions of CVA.
CSA
The discussion on residual exposure from CVA also applies in the context of FVA so that deviations from a perfect CSA could give rise to residual FVA. If we view FVA as the cost of providing an effective loan or the benefit of an effective deposit through a derivative then the residual exposure just gives rise to a residual funding cost or benefit. However, as will be discussed later, if we view the FVA as the cost of maintaining collateral on a hedge trade then the argument for residual FVA on CSA trades is much weaker, although funding costs and benefits will still arise from mismatches in collateral requirements due to differing CSA terms. What is clear is that FVA does not apply to the secured portion of the exposure unless the assets provided as collateral cannot be rehypothecated. Lack of rehypothecation may be due to legal terms within the CSA or because the asset provided as collateral may be ineligible under other CSAs.
CCP – Variation Margin
Given the degree of overcollateralisation for trades cleared through CCPs any residual exposure is likely to be small to zero. With this in mind the FVA component due to a mismatch between valuation and variation margin is likely to be close to zero.
Other Sources of FVA
Central counterparties also require that initial margin be posted in addition to variation margin. Large net risk positions can give risk to volatility buffers and all members of the CCP are required to contribute to a default fund that will be used to cover any losses in the event of the default of a member. All of this additional collateral needs to be funded through unsecured borrowing and hence gives rise to Margin Valuation Adjustment (MVA). Modelling the exposure at future times arising from these collateral buffers is complex. Initial margin is generally calculated using VaR models which means estimating expected future VaR. The volatility buffers use risk multipliers based on estimates of market depth so that large risk positions that cannot be quickly closed are penalised. The default fund, in the case of LCH, is based on all positions of all clearing members and so is very difficult to estimate as the positions of other members are unknown. In addition the methodology used by central counterparties is not always public, making models difficult to build.
The Basel Committee proposal on bilateral margin for financial counterparties BCBS 226 (2012h) and BCBS 242 (2013e) would similarly give rise to a funding requirement to maintain the initial margin collateral buffer.
Regulatory liquidity frameworks including FSA047/048 as applied in the UK (Financial Conduct Authority, 2014, section 12) and the liquidity framework under Basel III (BCBS, 2013b) also require the maintenance of an internal liquidity buffer to protect an institution from outflow in the event of a credit downgrade. This liquidity buffer has to be held in liquid assets by the bank against a two-notch downgrade of long-term rating by credit rating agencies. Many CSAs and ISDAs contain provisions for additional collateral in the event one or more rating agencies downgrade the counterparty below certain certain rating levels. In addition non-derivative products such as deposits may contain provisions to allow the counterparty to withdraw the deposit if the bank's credit rating falls below a certain level. The liquidity buffer must be funded through unsecured borrowing and hence is a type of FVA. Trades with counterparties that have embedded downgrade triggers in their documentation should include the cost of funding any additional liquidity buffer in the price of a new transaction.
1.3.6 Regulatory Capital and KVA
Under the Basel III framework (BCBS, 2011b) there are three key contributors to regulatory capital requirements:
• Market risk
• Counterparty Credit Risk (CCR)
• Regulatory CVA.
In addition some transactions will be subject to other capital provisions through Specific Risk, Incremental Risk Charge (IRC) and Wrong-way Risk. The incremental cost of capital due to a new trade is significant and has to be included in the price of a new derivative. This is not a funding cost, however, as there is no requirement to hold collateral or an asset return, rather there is a requirement to hold shareholders’ capital against the risk of loss on the derivative portfolio. This capital is not free and shareholders require a return on this capital. Often bank management will state a target return on capital or direct staff within the bank to accept transactions that exceed a minimum return on capital. The Basel framework requires an amount of capital to be held based on the application of the capital rules to the current portfolio, giving a spot capital requirement.9 However, the spot capital requirement is not necessarily a good measure of the expected capital requirement throughout the life of a transaction. An interest rate swap, for example, will be entered at close to zero value but will then diverge away from it, given additional CCR and CVA capital requirements during its lifetime. Hence the cost that needs to be priced into to new derivatives is the lifetime cost of capital which measures the cost of all future capital requirements. Part III discusses approaches to how this lifetime cost of capital can be estimated.
Once we have a measure of the lifetime cost of capital, KVA, then new transactions can be priced in such a way as to achieve the desired minimum profit to achieve the desired return for shareholders. However, this will not remain constant as market moves can lead to higher or lower capital requirements. Both the CCR and CVA terms are driven by the portfolio mark-to-market and so the lifetime cost of capital will have market risk sensitivities in a similar way to CVA and FVA. This leads to the question as to whether or not capital can be managed in a manner similar to CVA and FVA. It certainly can be managed passively through managing the back book of trades through novation and trade cancellation. Counterparties with large trade portfolios between them may find that capital as well as operational costs and risks can be reduced through compression trades
Of course with sufficiently large market moves, almost any initial margin can be exceeded as is clear from the removal of the CHF-EUR peg by the Swiss National Bank on 15 January 2015.
Note that sometimes this spot capital requirement is referred to in terms of
