Counterparty Risk and Funding: A Tale of Two Puzzles (Chapman and Hall/CRC Financial Mathematics Series)

"Solve the DVA/FVA Overlap Issue and Effectively Manage Portfolio Credit RiskCounterparty Risk and Funding: A Tale of Two Puzzles explains how to study risk embedded in financial transactions between the bank and its counterparty. The authors provide an analytical basis for the quantitative methodology of dynamic valuation, mitigation, and hedging of bilateral counterparty risk on over-the-counter (OTC) derivative contracts under funding constraints. They explore credit, debt, funding, liquidity, and rating valuation adjustment (CVA, DVA, FVA, LVA, and RVA) as well as replacement cost (RC), wrong-way risk, multiple funding curves, and collateral. The first part of the book assesses today's financial landscape, including the current multi-curve reality of financial markets. In mathematical but model-free terms, the second part describes all the basic elements of the pricing and hedging framework. Taking a more practical slant, the third part introduces a reduced-form modeling approach in which the risk of default of the two parties only shows up through their default intensities. The fourth part addresses counterparty risk on credit derivatives through dynamic copula models. In the fifth part, the authors present a credit migrations model that allows you to account for rating-dependent credit support annex (CSA) clauses. They also touch on nonlinear FVA computations in credit portfolio models. The final part covers classical tools from stochastic analysis and gives a brief introduction to the theory of Markov copulas.The credit crisis and ongoing European sovereign debt crisis have shown the importance of the proper assessment and management of counterparty risk. This book focuses on the interaction and possible overlap between DVA and FVA terms. It also explores the particularly challenging issue of counterparty risk in portfolio credit modeling. Primarily for researchers and graduate students in financial mathematics, the book is also suitable for financial quants, managers in banks, CVA desks, and members of supervisory bodies"-- "Preface Introduction The credit crisis and the ongoing European sovereign debt crisis have highlighted the native form of credit risk, namely counterparty risk. This is the risk of non-payment of promised cash flows due to the default of a party in an over the counter (OTC) derivative transaction. The value (price) of this risk has been initially called credit valuation adjustment (CVA), and the volatility of this value is of interest. A key related issue, especially with credit derivatives, is the so-called wrong way risk, i.e. the risk that occurs when exposure to a counterparty is adversely correlated with the credit quality of that counterparty. Moreover, as banks themselves have become risky, counterparty risk must be analyzed from the bilateral perspective: not only CVA needs to be accounted for, but also debt valuation adjustment (DVA), so that the counterparty risk of the two parties to the OTC contract are jointly accounted for in the modeling. In this context the classical assumption of a locally risk-free asset which is used for financing purposes (lending and borrowing as needed) is not sustainable anymore, which raises the companion issue of a proper accounting of the funding costs of a position (funding valuation adjustment (FVA), and liquidity valuation adjustment (LVA) when considered net of credit spread). The last related issue is that of replacement cost (RC) corresponding to the fact that at the default time of a party the valuation of the contract by the liquidator may differ from the economic value of the contract (cost of the hedge) right before that time"-- � Read more... Content: Financial Landscape A Galilean Dialogue on Counterparty Risk, CVA, DVA, Multiple Curves, Collateral, and Funding To the Discerning Reader The First Day The Second Day The Third Day The Fourth Day The Whys of the LOIS Financial Setup Indifference Valuation Model LOIS Formula Numerical Study Model-Free Developments Pure Counterparty Risk Cash Flows Valuation and Hedging CSA Specifications Bilateral Counterparty Risk under Funding Constraints Introduction Market Model Trading Strategies Martingale Pricing Approach TVA Example Reduced-Form BSDE Modeling A Reduced-Form TVA BSDE Approach to Counterparty Risk under Funding Constraints Introduction Pre-Default BSDE Modeling Markov Case The Four Wings of the TVA Introduction TVA Representations CSA Specifications Clean Valuations TVA Computations Dynamic Copula Models Dynamic Gaussian Copula Model Introduction Model Clean Valuation and Hedging of Credit Derivatives Counterparty Risk Common-Shock Model Introduction Model of Default Times Clean Pricing, Calibration and Hedging Numerical Results CVA Pricing and Hedging CVA Computations for one CDS in the Common-Shock Model Introduction Generalities Common-Shock Model with Deterministic Intensities Numerical Results with Deterministic Intensities Common-Shock Model with Stochastic Intensities Numerics CVA Computations for Credit Portfolios in the Common-Shock Model Portfolio of CDS CDO Tranches Further Developments Rating Triggers and Credit Migrations Introduction Credit Value Adjustment and Collateralization under Rating Triggers Markov Copula Approach for Rating-Based Pricing Applications A Unified Perspective Introduction Marked Default Time Reduced-Form Modeling Dynamic Gaussian Copula TVA Model Dynamic Marshall-Olkin Copula TVA Model Mathematical Appendix Stochastic Analysis Prerequisites Stochastic Integration Ito Processes Jump-Diffusions Feynman-Kac Formula Backward Stochastic Differential Equations Measure Changes and Random Intensity of Jumps Reduction of Filtration and Hazard Intensity Pre-Default Credit Risk Modeling Markov Consistency and Markov Copulas Introduction Consistent Markov Processes Markov Copulas Examples Index Abstract: "Solve the DVA/FVA Overlap Issue and Effectively Manage Portfolio Credit RiskCounterparty Risk and Funding: A Tale of Two Puzzles explains how to study risk embedded in financial transactions between the bank and its counterparty. The authors provide an analytical basis for the quantitative methodology of dynamic valuation, mitigation, and hedging of bilateral counterparty risk on over-the-counter (OTC) derivative contracts under funding constraints. They explore credit, debt, funding, liquidity, and rating valuation adjustment (CVA, DVA, FVA, LVA, and RVA) as well as replacement cost (RC), wrong-way risk, multiple funding curves, and collateral. The first part of the book assesses today's financial landscape, including the current multi-curve reality of financial markets. In mathematical but model-free terms, the second part describes all the basic elements of the pricing and hedging framework. Taking a more practical slant, the third part introduces a reduced-form modeling approach in which the risk of default of the two parties only shows up through their default intensities. The fourth part addresses counterparty risk on credit derivatives through dynamic copula models. In the fifth part, the authors present a credit migrations model that allows you to account for rating-dependent credit support annex (CSA) clauses. They also touch on nonlinear FVA computations in credit portfolio models. The final part covers classical tools from stochastic analysis and gives a brief introduction to the theory of Markov copulas.The credit crisis and ongoing European sovereign debt crisis have shown the importance of the proper assessment and management of counterparty risk. This book focuses on the interaction and possible overlap between DVA and FVA terms. It also explores the particularly challenging issue of counterparty risk in portfolio credit modeling. Primarily for researchers and graduate students in financial mathematics, the book is also suitable for financial quants, managers in banks, CVA desks, and members of supervisory bodies"-- "Preface Introduction The credit crisis and the ongoing European sovereign debt crisis have highlighted the native form of credit risk, namely counterparty risk. This is the risk of non-payment of promised cash flows due to the default of a party in an over the counter (OTC) derivative transaction. The value (price) of this risk has been initially called credit valuation adjustment (CVA), and the volatility of this value is of interest. A key related issue, especially with credit derivatives, is the so-called wrong way risk, i.e. the risk that occurs when exposure to a counterparty is adversely correlated with the credit quality of that counterparty. Moreover, as banks themselves have become risky, counterparty risk must be analyzed from the bilateral perspective: not only CVA needs to be accounted for, but also debt valuation adjustment (DVA), so that the counterparty risk of the two parties to the OTC contract are jointly accounted for in the modeling. In this context the classical assumption of a locally risk-free asset which is used for financing purposes (lending and borrowing as needed) is not sustainable anymore, which raises the companion issue of a proper accounting of the funding costs of a position (funding valuation adjustment (FVA), and liquidity valuation adjustment (LVA) when considered net of credit spread). The last related issue is that of replacement cost (RC) corresponding to the fact that at the default time of a party the valuation of the contract by the liquidator may differ from the economic value of the contract (cost of the hedge) right before that time" And Funding; To the Discerning Reader; The First Day; The Second Day; The Third Day; The Fourth Day The Whys of the LOIS; Financial Setup; Indifference Valuation Model; LOIS Formula; Numerical Study Model-Free Developments; Pure Counterparty Risk; Cash Flows; Valuation and Hedging; CSA Specifications Bilateral Counterparty Risk under Funding Constraints; Introduction; Market Model; Trading Strategies; Martingale Pricing Approach; TVA; Example Reduced-Form BSDE Modeling; A Reduced-Form TVA BSDE Approach to Counterparty Risk under Funding Constraints; Introduction; Pre-Default BSDE Modeling; Markov Case The Four Wings of the TVA; Introduction; TVA Representations; CSA Specifications; Clean Valuations; TVA Computations Dynamic Copula Models; Dynamic.;; Stochastic Integration; Itô Processes; Jump-Diffusions; Feynman-Kac Formula; Backward Stochastic Differential Equations; Measure Changes and Random Intensity of Jumps; Reduction of Filtration and Hazard Intensity Pre-Default Credit Risk Modeling Markov Consistency and Markov Copulas; Introduction; Consistent Markov Processes; Markov Copulas; Examples Index.;Gaussian Copula Model; Introduction; Model; Clean Valuation and Hedging of Credit Derivatives; Counterparty Risk Common-Shock Model; Introduction; Model of Default Times; Clean Pricing,;Calibration and Hedging; Numerical Results; CVA Pricing and Hedging CVA Computations for one CDS in the Common-Shock Model; Introduction; Generalities; Common-Shock Model with Deterministic Intensities; Numerical Results with Deterministic Intensities; Common-Shock Model with Stochastic Intensities; Numerics CVA Computations for Credit Portfolios in the Common-Shock Model; Portfolio of CDS; CDO Tranches Further Developments; Rating Triggers and Credit Migrations; Introduction; Credit Value Adjustment and Collateralization under Rating Triggers; Markov Copula Approach for Rating-Based Pricing; Applications A Unified Perspective; Introduction; Marked Default Time Reduced-Form Modeling; Dynamic Gaussian Copula TVA Model; Dynamic Marshall-Olkin Copula TVA Model Mathematical Appendix; Stochastic Analysis Prerequisites.;Financial Landscape; A Galilean Dialogue on Counterparty Risk, CVA, DVA, Multiple Curves, Collateral,;Solve the DVA/FVA Overlap Issue and Effectively Manage Portfolio Credit RiskCounterparty Risk and Funding: A Tale of Two Puzzles explains how to study risk embedded in financial transactions between the bank and its counterparty. The authors provide an analytical basis for the quantitative methodology of dynamic valuation, mitigation, and hedging of bilateral counterparty risk on over-the-counter (OTC) derivative contracts under funding constraints. They explore credit, debt, funding, liquidity, and rating valuation adjustment (CVA, DVA, FVA, LVA, and RVA) as well as replacement cost (RC), wrong-way risk, multiple funding curves, and collateral. "Solve the DVA/FVA Overlap Issue and Effectively Manage Portfolio Credit RiskCounterparty Risk and Funding: A Tale of Two Puzzles explains how to study risk embedded in financial transactions between the bank and its counterparty. The authors provide an analytical basis for the quantitative methodology of dynamic valuation, mitigation, and hedging of bilateral counterparty risk on over-the-counter (OTC) derivative contracts under funding constraints. They explore credit, debt, funding, liquidity, and rating valuation adjustment (CVA, DVA, FVA, LVA, and RVA) as well as replacement cost (RC), wrong-way risk, multiple funding curves, and collateral. The first part of the book assesses today's financial landscape, including the current multi-curve reality of financial markets. In mathematical but model-free terms, the second part describes all the basic elements of the pricing and hedging framework. Taking a more practical slant, the third part introduces a reduced-form modeling approach in which the risk of default of the two parties only shows up through their default intensities. The fourth part addresses counterparty risk on credit derivatives through dynamic copula models. In the fifth part, the authors present a credit migrations model that allows you to account for rating-dependent credit support annex (CSA) clauses. They also touch on nonlinear FVA computations in credit portfolio models. The final part covers classical tools from stochastic analysis and gives a brief introduction to the theory of Markov copulas. The credit crisis and ongoing European sovereign debt crisis have shown the importance of the proper assessment and management of counterparty risk. This book focuses on the interaction and possible overlap between DVA and FVA terms. It also explores the particularly challenging issue of counterparty risk in portfolio credit modeling. Primarily for researchers and graduate students in financial mathematics, the book is also suitable for financial quants, managers in banks, CVA desks, and members of supervisory bodies"-- Provided by publisher "Preface Introduction The credit crisis and the ongoing European sovereign debt crisis have highlighted the native form of credit risk, namely counterparty risk. This is the risk of non-payment of promised cash flows due to the default of a party in an over the counter (OTC) derivative transaction. The value (price) of this risk has been initially called credit valuation adjustment (CVA), and the volatility of this value is of interest. A key related issue, especially with credit derivatives, is the so-called wrong way risk, i.e. the risk that occurs when exposure to a counterparty is adversely correlated with the credit quality of that counterparty. Moreover, as banks themselves have become risky, counterparty risk must be analyzed from the bilateral perspective: not only CVA needs to be accounted for, but also debt valuation adjustment (DVA), so that the counterparty risk of the two parties to the OTC contract are jointly accounted for in the modeling. In this context the classical assumption of a locally risk-free asset which is used for financing purposes (lending and borrowing as needed) is not sustainable anymore, which raises the companion issue of a proper accounting of the funding costs of a position (funding valuation adjustment (FVA), and liquidity valuation adjustment (LVA) when considered net of credit spread). The last related issue is that of replacement cost (RC) corresponding to the fact that at the default time of a party the valuation of the contract by the liquidator may differ from the economic value of the contract (cost of the hedge) right before that time"-- Provided by publisher Chapter 5: A Reduced-Form TVA BSDE Approach to Counterparty Risk under Funding ConstraintsChapter 6: The Four Wings of the TVA; Part IV: Dynamic Copula Models; Chapter 7: Dynamic Gaussian Copula Model; Chapter 8: Common-Shock Model; Chapter 9: CVA Computations for One CDS in the Common-Shock Model; Chapter 10: CVA Computations for Credit Portfolios in the Common-Shock Model; Part V: Further Developments; Chapter 11: Rating Triggers and Credit Migrations; Chapter 12: A Unified Perspective; Part VI: Mathematical Appendix; Chapter 13: Stochastic Analysis Prerequisites Front Cover; Contents; Preface; Introduction; Outline; About the title of the book; Standing Notation, Terminology and Assumptions; Bibliographic Guidelines; Acknowledgements; Part I: Financial Landscape; Chapter 1: A Galilean Dialogue on Counterparty Risk, CVA, DVA, Multiple Curves, Collateral and Funding; Chapter 2: The Whys of the LOIS; Part II: Model-Free Developments; Chapter 3: Pure Counterparty Risk; Chapter 4: Bilateral Counterparty Risk under Funding Constraints; Part III: Reduced-Form BSDE Modeling Chapter 14: Markov Consistency and Markov CopulasBibliography; Back Cover