In-depth industry interviews reveal evolving approaches for pricing and managing counterparty risk
The market volatility experienced during the crisis has forced financial institutions to reassess their traditional approach to counterparty credit risk. Many banks have moved beyond the control mindset of credit limits to dynamically pricing counterparty credit risk (CCR) directly into new trades using Credit Value Adjustment (CVA) to price the counterparty risk.
This is one of the findings from a white paper, released by Algorithmics, that examines how institutions are using CVA – how it is currently being measured, where CVA fits into existing systems and how CVA practices are expected to evolve.
Bob Boettcher, senior director, Product Strategy, Algorithmics, said: “Many institutions are pricing CVA into trades at deal time, and are investing heavily to enhance their counterparty risk system capabilities. When institutions have the ability to calculate real-time incremental CVAs rather than relying upon simple CVA add-ons, they gain the ability to price trades that lead to risk reduction more aggressively than risk increasing trades. We see much of the push for incremental CVA coming from the front office, with traders concerned that the inability to properly assess CVA is resulting in lost business due to the use of simple, overly-conservative charges.”
As part of its ongoing research, Algorithmics conducted in-depth interviews to gain insight into how firms are currently measuring CVA and how CVA practices are expected to evolve. Key findings:
• Many institutions said that they had under-emphasized CCR since a significant amount of their derivatives exposure was with counterparties that were perceived to be “too big to fail”.
• Other institutions relied only on limits as a means of preventing the exposure to any single counterparty becoming excessive, but did not actively price or manage the underlying risk.
• Some financial institutions used CVA to price the counterparty risk in their derivatives books, but without recognition of their own potential default.
Bob Boettcher concluded: “Counterparty credit risk has rapidly become the problem of all financial institutions, big or small. We see institutions changing their approach to counterparty risk with improvements to the traditional methods for measurement and control and many are now starting to implement CVA programs. Proper management of pre-deal pricing and transaction structuring can provide firms with a competitive advantage and pioneering firms that accurately assess and integrate CVA within their risk culture are better able to pursue an overall risk strategy by providing transaction level incentives for the front office.”
