The next step in derivatives portfolio management

Evolution in the risk landscape of OTC derivatives

Since the financial crisis, there have been a number of significant evolutions in the management of OTC derivatives. From a derivative pricing perspective, it has become a prevalent practise to include certain costs in the OTC derivatives valuation that in many cases had previously been ignored: the so-called XVAs. Whereas prior to the crisis, pricing adjustments were primarily related to the cost of hedging of counterparty credit risk (CVA), banks are now assessing other costs such as capital, funding and liquidity costs. From a risk perspective, a drive towards collateralisation has led to a significant increase in liquidity and funding requirements for OTC derivatives portfolios. Indeed, the move towards daily margining has reduced counterparty exposures; however, it has led to a greater uncertainty in cash flows and thus posing an increased liquidity risk.

Deloitte has developed an integrated OTC derivative solution that derives the relevant exposure profiles and liquidity metrics for portfolios spanning a wide range of different product classes. The tool provides a unified framework with a simultaneous full portfolio revaluation, allowing for a consistent derivation of all relevant risk metrics:

• Counterparty Credit Risk: expected positive exposure (EPE), potential future exposure (PFE)
• Liquidity Risk: expected cash flow profile, worst-case cash-flows
• XVAs

The rise of XVAs

The financial crisis revealed that counterparty credit, funding and liquidity risks associated with OTC derivatives can be very substantial (e.g. CVA losses caused by US monoliners) and ought to be mitigated. Market participants incur counterparty credit risk hedging costs through their CVA management activities. In recent years, banks have been taking into account further costs in their OTC derivatives business including capital costs (KVA), funding costs (FVA & MVA) as well as liquidity considerations.

Drive to collateralisation – shift towards liquidity and funding risks

The CVA losses experienced during the crisis as well as the increasing capital costs for counterparty credit risk under Basel III have led to an industry-wide drive towards mitigating counterparty credit risk. On the one hand, more and more vanilla derivatives are being centrally cleared through CCPs for which daily margining is required. On the other hand, new regulations such as the BCBS IOSCO Initial Margin (BCBS 317) have increased the prevalence of margin exchanges for non-centrally cleared derivatives.

This drive towards collateralisation does not mean that derivatives portfolios have become risk-free. Whereas posting margin reduces counterparty exposures, it also leads to greater unpredictability in daily cash flows. Indeed, periods of high market volatility will lead to significant mark-to-market fluctuations in the derivatives portfolio, which in turn leads to greater collateral payments. The reduction in counterparty credit risk thus comes hand in hand with an increase in liquidity risk.

Banks will have to monitor even more closely the amounts of liquidity they are holding. Holding too many liquid assets can be expensive; however, not holding enough is detrimental. An adequate measure of liquidity will have to be able to capture the impact of abrupt changes market volatility on their portfolio.

The OTC derivatives management tool

The OTC derivatives tool creates a unified framework enabling a simultaneous full portfolio revaluation, allowing for a consistent derivation of all relevant risk metrics (Counterparty Credit Risk, Liquidity Risk and XVAs). The tool consists of four components:

Risk Factor generation:

The Monte Carlo simulation engine is driven by a set of stochastic valuation models (Heston, SABR, Black-Scholes, etc.) that generate joint realisations of the relevant risk factor profiles. The risk-factor generation allows for both a real-world and market-implied generation of risk-factors. The latter is particularly relevant for the calculation of XVAs, where one requires consistency with front office pricing models.

Derivatives Pricing:

Conditional on a realisation of the risk-factor profiles, the tool performs a full revaluation of all derivatives in the portfolio. The tool includes a valuation library covering a wide range of different derivatives.

Application of collateralisation rules:

In each Monte Carlo scenario, collateralisation rules are applied to estimate the net exposure towards the counterparty, as well as the net cash flows. The tool allows for many different types of CSA agreements (collateralisation frequency, threshold, minimum transfer amount,…)

Aggregation across Monte Carlo scenarios:

Taking either an average or a quantile of the exposure and cash flow profiles across the different Monte Carlo scenarios yields the key risk metrics.