IMPORTANT NOTES WHEN WORKING WITH SCREENSHOW'S PRINTING INSTRUCTIONS In order to print correctly,...

RiskDeutsche Bank

Credit Risk of Derivatives

Exposure Management Group

RiskDeutsche Bank Exposure Management Group

Exposure Management: Roles & Responsibilities

Analysis of derivatives risk of structured transactions, impact of new trades on existing portfolios.

Counterparty portfolio analysis: monitoring of critical portfolios and analysis of unprocessed trades.

Advise and support CRM and business on risk mitigation.

Development of pre-deal check tools.

Development of risk methodology together with MRM Derivatives Exposure and review of internal and external margining methodologies (e.g. Clearing Houses).

Bank portfolio (and sub-portfolio) analysis: exposure reports for targeted products or regions (e.g. commodities or Emerging markets) via derivatives stress test analysis.

Risk assessment within the New Product Approval (NPA) process.

Ultimate Goal: optimize the credit risk within the parameters set by the credit officers, i.e. maximize the return on the risk at the firm-wide portfolio level.

1.Introduction to Exposure

Management

2.Exposure Modelling &

Measurement

3.Simple Derivative Products

4.Risk Reducing Techniques

5.Stress Tests

2


Overview of Credit Risk/ Exposure

Credit Risk: risk of a loss, arising from counterparty’s inability to meet its obligations on a financial contract

Credit Exposure: is a measure of the amount that would be lost if a counterparty to a financial contract defaults

Credit exposure on a straight loan ~ loan notional Credit exposure on a derivative instrument = Replacement value, if

positive. Credit Exposure of traded products is measured via two concepts:

Current Credit Exposure (CCE)

Potential Future Exposure (PFE)

For collateralized counterparties (except HF) → short-term PFE

(VaR), the risk is calculated over the respective call frequency

period + liquidation period (usually 10 business days)

For Hedge Funds monitoring is based on stress test shortfall

3


Management


Measurement



5.Stress Tests


Measuring counterparty exposure: CCE

Current Credit Exposure (CCE):

CCE is calculated as a replacement value of the derivative, applying enforceable netting rules (Credit Line Netting) and collateral, if applicable.

CCE depends on current market conditions (IRs, FX rates, equity prices, credit spreads, inflation, volatility, hidden market conditions as liquidity).

CCE is monitored under the CCE Limit, set by each credit officer in accordance to the present credit risk appetite;

CCE is the legally binding exposure in case of counterparty’s default.

4

1. Introduction to Exposure

Management

2. Exposure Modelling &

Measurement

3. Simple Derivative Products

4. Risk Reducing Techniques

5. Stress Tests


CCE: Impact of Credit Line Netting (“Close Out” Netting)

Example: all numbers from DB perspective

DB has entered into two derivative transactions with a counterparty. 1st transaction has a MtM of + 32 (i.e. the counterparty owes DB) and 2nd transaction has a MtM of -10 (i.e. DB owes the counterparty).

CCE with netting: + 32 - 10 = 22

CCE without netting: = 32

Without netting in the case of ctpy’s default, DB will still have the obligation to pay 10 (DB owes it to the counterparty), but the 32 would go into the bankrupt’s liabilities.

5


Management


Measurement



5.Stress Tests


Measuring counterparty exposure: PFE

Potential Future Exposure (PFE):

PFE quantifies the potential adverse movement of the trade/ portfolio CCE due to changes in the underlying asset (IR, FX, equity, etc.);

PFE varies over time as the market conditions might alter and the trade gets closer to maturity (aging effect);

The PFE utilisation is calculated over the lifetime of the trade, i.e. PFE Profile.

PFE is monitored under the PFE limit for the respective future tenor point , i.e. PFE Limit Structure;

6


Management


Measurement

3. Risk Systems Overview


5. Case Study


7. Stress Tests

8. Policy Overview


PFE Considerations

The PFE gives a „reasonable worst case“ exposure, considering counterparty’s default and adverse market scenario.

The PFE utilisation is calculated over the lifetime of the trade, i.e. PFE Profile.

It is measured at 95% confidence level → 95% probability that the exposure of a trade/ portfolio will stay below the PFE number.

Tail risk: up to 5% probability the trade/ portfolio exposure to exceed the PFE number due to extreme market movements (e.g. Global Crisis in 2008/ 2009).

The PFE calculation approach should be:

conservative enough to protect the bank;

backed up by historical analysis (backtesting); macroeconomic analysis & product expertise are considered by the scenario definition;

consistent over different product classes (e.g. FX Forwards & CCSwaps);

take into account the tenor of the transaction;

consider the specifics of the underlying, e.g. distinguish between high/ low volatility assets (DM vs. EM underlying), liquid/ illiquid assets.

7


Management


Measurement



5.Stress Tests


PFE Profile Example: 5Y “at the money” IRS

The result of the PFE calculation is a whole pattern, i.e. PFE profile

The calculation considers the maturity of the trade and the so called “aging effect” (the exposure decreases with each coupon payment)

8


Management


Measurement

3.Risk Systems Overview


5.Case Study


7.Stress Tests

8.Policy Overview


Risk Measurement for Collateralized Counterparties (1)

Collateral is valued at its current market value pre-haircut.

Accordingly, a PFE estimate is needed to value the market movements impact on the CCE in the future.

The PFE estimate, called short-term PFE (VaR), should reflect changes in DB’s exposure.

The short-term PFE (VaR) is monitored vs. PFE (VaR) Limit.

The PFE calculation should also reflect potential changes in the value of the collateral taking into account correlation.

The risk horizon for the exposure calculation depends on the call frequency, it is usually calculated as:

Risk horizon = Call frequency + 10 bdays (liquidation period)

The most fundamental evaluation of the risk is the CCE.

CCE = Portfolio MtM (netting applied) + Collateral posted – Collateral held

9


Management


Measurement



5.Stress Tests

Exposure Management GroupRiskDeutsche Bank

Time Horizon for a PFE calculation with daily margining: 10 bdays/ 14 calendar days

In DB Risk systems the calculation is done over the immediate next 10 business days (i.e. 14 calendar days by daily margining).

Short-term PFE (VaR) = 10bdays PFE – CCE after Collateral

However, the risk over any 10 bdays period in the life of the portfolio should be considered.

Risk Measurement for Collateralized Counterparties (2)

10

TODAY MATURITY

[ 10 DAYS

[ 10 DAYS

[ 10 DAYS [ 10 DAYS


Simple Derivatives Products: Overview

Forward

Interest Rate Swap (IRS)

Swaption

Options

11


Management


Measurement



5.Stress Tests


Simple Derivatives Products: Introduction to Exposure Calculation

The exposure calculation involves always the following steps:

Step 1: Understand the trade structure and identify the main risk drivers

Trade cashflows and respective risk driver, e.g. FX spot rates, equity prices, IRs, CS, etc.

Step 2: Identify the trade sensitivity (impact of the underlying on the CCE)

Appreciation/ depreciation of base currency, increasing/ decreasing stock prices, increasing/ decreasing IRs, credit spreads widening/ tightening

Step 3: Model the underlying (simulate future levels)

E.g. FX rates are assumed to be log-normally distributed

Step 4: Re-price the product using the simulated levels of the underlying, determine CCE & PFE

12


Management


Measurement



5.Stress Tests


Forwards

A forward contract is an agreement between two counterparties that fixes the terms of an exchange that will take place between them at some future date.

The contract specifies the underlying, the price at which the exchange takes place (strike) and the date (or range of dates) in the future when the exchange will take place.

A forward contract is a contract for forward delivery. No intermediate cashflows until delivery.

Forward contracts are tailor made - both the size of the transaction and the date of forward delivery are agreed between the counterparties.

Compare to Futures!

13


Management


Measurement



5.Stress Tests


Forwards: Specifics

Settlement risk considerations for FX:

In an FX forward both parties exchange a currency amount.

This exchange is mostly free of delivery, i.e. unsafe settlement.

If the settlement fails, the full amount DB expects is at risk.

Due to the global nature of the business and time lags between different locations, a whole time window has to be monitored (extended liquidation period).

FX Settlement Limit in Paragon should be set up!

Forward on equity: forward on counterparty’s own shares

Basic assumption of each PFE calculation in such cases: the counterparty has defaulted!

In this case the share price can be assumed to drop to zero!

In a forward sale the MtM and therefore the PFE is 100% of the notional!

We call this Wrong-Way Risk!

14


Management


Measurement

3. Simple Derivative

Products


5. Stress Tests


FX Forward*: Example

Main risk driver: EUR/ USD FX rate

Trade sensitivity: USD depreciation vs. EUR Assume USD depreciates vs. EUR to 1.42 USD/ EUR

Then the MtM of the trade will be positive for DB as under the Forward DB is supposed to pay only 1.3633 USD for 1 EUR instead of the market rate of 1.42 USD/ EUR (i.e. less than market)

Note that a series of FX Forwards is called a “Strip”.

15

DB Ctpy

USD 13.63 mn

EUR 10 mn

Example: DB buys EUR 10 mn vs. USD @ a strike of 1.3633 USD/ EUR in 12M1.Introduction to Exposure

Management


Measurement



5.Stress Tests

*FX = Foreign Exchange


FX Forward: Modelling the Underlying Risk Factor (1)

The model assumes that financial assets follow a random walk without drift for Developed markets; for Emerging markets jump factors may be included.

Efficient market hypothesis (weak form): the current security price instantaneously and fully reflects all information contained in the past history of the security price.

For exposure purposes in closed form this translates to the log-normal distribution.

Model simplification (stress formula):

Stressed Spot = Spot * exp( ±1,645 * Vol * √ Time )

From statistics:

±1,645 is the z-value of the normal distribution (Gauss’ bell curve) – representing the confidence level of 95 %

Vol = Volatility: based on historical data, the volatility measures the fluctuation

√ Time = square root of time in years

16


Management


Measurement



5.Stress Tests


FX Forward: Modelling the Underlying Risk Factor (2)

Exercise:

What would be the stressed EUR/ USD level in 12 months considering the following input values?

Hint: use the stress formula!

Spot level: 1.3647 USD/ EUR Z-value: 1.645 Volatility: 9.8% Time to maturity: 12 months

17


Management


Measurement

3. Risk Systems Overview


Products

5. Case Study


7. Stress Tests

8. Policy Overview


18

EUR/ USD FX Simulation: Example

Application of the model to the EUR/ USD FX rate, trading at 1.3647 USD/ EUR

Advantage of the log-normal model:

Simulated levels of the underlying risk factor are always positive!

Toda

y1

D2

D3

D5

D7

D10

D14

D21

D30

D37

D44

D

61 D

75 D

90 D

104

D

121

D

135

D

151

D

181

D

212

D

242

D

273

D

303

D

334

D

364

D

1.10

1.20

1.30

1.40

1.50

1.60

1.70

EUR / USD FX Rate

95th percentile

5th percentile

Simulation time points: more narrow at the beginning, more spread out in the future


FX Forward: Quick PFE Calculation

19


Management


Measurement



5.Stress Tests

6.Policy Overview

To get a PFE number, the simulated levels of the EUR/ USD FX are used.

For a quick proxy, the stress formula could be used to “simulate” the FX rate at maturity:

Simulated EUR/ USD FX: 1.3633 * exp(1.645 * 9.8% * √1)) = 1.6034

Peak PFE is then calculated by re-pricing the trade at the potential future FX rate:

Peak PFE in EUR = EUR 10 mn – USD 13.633 mn/ 1.6034 = EUR 1.4975 mn

PROs: very quick, gives a good proxy of the FX risk for short-term DM currencies

CONs: only Peak PFE, no PFE profile, not appropriate for EM nor trades with peak not at maturity

For a PFE Profile on plain vanilla trades cEIS Pre-Deal Checker to be used: a full simulation of the FX rate by Matrix, re-pricing at each timepoint on the grid


Interest Rate Swap (IRS)

Role of the swap market:

The swap market helps issuers to find a financing corresponding to their specific needs by

attracting investors with certain characteristics.

Banks act as mediator between issuers and investors vs. compensation.

The swap market is used to transformed fixed to floating coupons and vice versa.

Swap marke

t

20


Management


Measurement




6.Stress Tests


Interest Rate Swap (IRS): Example

Notional: EUR 100 mn

Tenor: spot – 5Y

DB pays: 3M Euribor, QTR, act/ 360

DB receives: 0.75% p.a., QTR, act/ 360

Trade sensitivity: falling EUR interest rates

Interpretation:

DB receives a fixed rate, hence if the EUR IRs fall, DB will receive a higher than the market implied

rate, meaning the value of the swap will increase

DB Ctpy

3M Euribor

0.75% p.a.

21


Management


Measurement




6.Stress Tests


Options: Definitions

Definition: an option is a contract that gives the holder the right, but not the obligation to buy (call) from / sell (put) to the option writer a certain asset (here FX amount) at a pre-determined price (strike) on a future time point (exercise date).

Option positions:

Option position Trading name Description

Buy Call Long Call Right to buy an asset

Sell Call Short CallObligation to sell an asset

upon exercise to the holder

Buy Put Long Put Right to sell an asset

Sell Put Short PutObligation to buy an asset

upon exercise from the holder

Option styles:

European style: exercise possible only on expiry date

American style: exercise at any time up to and including expiry date

Bermudan style: exercise at several pre-defined time points up to and including expiry date

Asian style: the payoff depends on the average underlying price over a pre-set period of time

Main risk driver: change in the market price of underlying, e.g. share price, FX rate, etc.

22


Management


Measurement



5.Stress Tests


Payout Diagram of a Bought Call Option (Exposure Perspective)

23

*ATM: „at the money“

Option premium ignored for simplicity! Main risk driver: underlying asset price, sensitivity to increasing prices Call options sold to non-collateralized counterparties are risk free, to collateralized counterparties bear

claw-back risk!

-0.1

0.0

0.1

1.30 1.35 1.40 1.45 1.50

ATM*

“In the money”“Out of the money”

Exposure

USD/ EUR

0.1

0.1

0.1


Payout Diagram of a Bought Put Option (Exposure Perspective)

24

*ATM: „at the money“

Option premium ignored for simplicity! Main risk driver: underlying asset price, sensitivity to falling prices Put options sold to non-collateralized counterparties are risk free, to collateralized counterparties bear claw-

back risk!

-0.1

0.0

0.1

1.30 1.35 1.40 1.45 1.50

“In the money” “Out of the money”

ATM*

Exposure

0.1

0.1

0.1 USD/ EUR


Combined Option Positions (Exposure Perspective)

25

Combined Option Position = synthetic asset position without buying/ selling the asset

By European Options = Forward contract

=+

Long Call Synthetic Long Asset

Short Put

=+

Long PutShort Call Synthetic Short Asset


Risk Reducing Techniques: Overview

Early Termination Clauses (ETCs)

A technique to reduce the economic tenor of the transaction to a duration proportional to the counterparty’s credit standing and CO’s risk appetite

The transaction is settled at the MtM on the exercise date;

Only mutual termination clauses are relevant for the exposure calculation;

Collateral agreement (CSA: Collateral Support Annex): exposure calculation over the relevant margin call frequency period and monitoring under the PFE (VaR) limit.

Dynamic Credit Hedging

The exposure is hedged via CDS contracts;

Objective: maintain the P&L impact of a counterparty’s default within the pre-defined credit lines;

26


Management


Measurement



5.Stress Tests


Early Termination Clause (ETC): Definition

Longer dated trades should contain an ETC, in specific:

Trades with tenor > 10y for uncollateralized counterparties

Trades with tenor > 30y for collateralized counterparties

ETCs are defined as either:

Mandatory Cash Settlement Clause: settlement at current MtM at a specified date

Optional Early Termination Clause (Mutual Termination Clause): right to call on one or more dates to terminate the transaction vs. settlement at current MtM

Trigger based Optional Early Termination Clause: optional termination by the non-affected party upon a trigger event (e.g. rating downgrade) vs. current MtM

PFE and Limit tenors (system implementation since 2014):

For Mandatory Early Termination Clauses exposure is calculated till the first termination date.

For Optional Early Termination Clauses exposure is calculated till maturity, tenor breach if tenor of the limit is earlier than next ETC and maturity.

For Trigger based Optional ETC exposure is calculated till maturity.

27


Management


Measurement



5.Stress Tests


Collateral Agreement: Terms

The Credit Officer is responsible for defining the following parameters:

CCE Limit: represents DB’s risk appetite; generally a multi-product limit to cover all products traded under the collateral agreement.

PFE (VaR) Limit: should cover Threshold Amount + MTA + PFE (VaR)

Collateral Plan Type: unilateral (one-sided, i.e. supranational & international institutions) or bilateral (both counterparties post collateral)

Call Frequency: preferred is daily, it depends on the client’s operational capacity to value the portfolio and execute margin calls

Threshold Amount & rating triggers: preferred is zero threshold;

If CCE < Threshold → collateral is NOT required

Independent Amount (Initial Margin), usually for Hedge Funds, upfront collateral to cover potential MtM movements between collateral calls

Minimum Transfer Amount (MTA): collateral requirement must exceed the MTA prior to any collateral exchange (minimize the number of collateral transfers)

Eligible Collateral: the collateral should be LIQUID (easy to liquidate in case of default), preferred: Cash and Government bonds, see “Collateralized Trading Policy” for details

Product Coverage

Rounding Increment (preferred: small, e. g. EUR 0.1m)

28


Management


Measurement



5.Stress Tests


Calculation of Collateral Calls (1)

Collateral calls are typically calculated as follows:

MtM of all trades covered by the agreement (netting applied)

+ Independent Amount

- Threshold Amount (uncollateralized exposure)

= Credit Support Amount

- Collateral Held

= Delivery / Return Amount

If Delivery/ Return Amount > MTA amount, it is rounded according to the Rounding Increment to give the final Collateral Call Amount.

Exposure Threshold MTARounding Increment

Action

23 20 5 2 No margin call

23 20 0 2 Call 4

23 20 2 2 Call 4

17 20 2 2 Return 2

29


Management


Measurement


4. Risk Reducing

Techniques

5. Stress Tests


Calculation of Collateral Calls (2)

Exercise:

Consider the following situation:

CCE: EUR 16 mn

Threshold: EUR 15 mn

MTA: EUR 3 mn

Rounding increment: EUR 1 mn

Is DB entitled to execute a collateral call?

30


Management


Measurement



5.Stress Tests


Eligible Collateral and HaircutsCollateralized Trading Policy

According to the “Collateralized Trading Policy” (May 2014) eligible collateral includes:

Currencies of major developed markets: USD, GBP, EUR, JPY, CAD, AUD & CHF

Highly liquid, easily priced, capital efficient marketable securities, currently government bonds of: USA, UK, Germany, France, Japan, Canada, Switzerland, Denmark, Netherlands

Cash and or securities should be held either by Deutsche Bank or preferred third party custodians.

Non-standard collateral is considered on a case by case basis subject to approval by CM, Treasury, business, Legal and CRM (at least A2) with guidance from EMG.

31


Management


Measurement



5.Stress Tests


Collateralized Counterparties: Practical Aspects

How much business could be done under a collateral plan?

The potential trading volume depends on the difference between PFE (VaR) Limit and (Threshold + MTA). The greater the room for potential CCE changes, the bigger the business volume that could be accommodated under the limit.PFE (VaR) limit > Threshold + MTA, otherwise the relationship is effectively uncollateralized.In addition to the portfolio PFE (VaR) in cEIS following is reported:

Total Exposure = CCE after collateral + PFE (VaR)

Availability under the PFE (VaR) limit calculated as:

PFE (VaR) Limit – { Max [(CCE after Collateral); (Threshold + MTA)] + PFE (VaR)}

Variation Margin (Collateral): received or posted, direct feed from dbMargin and Initial Margin (upfront collateral)

32


Management


Measurement



5.Stress Tests


Stress Test: Overview

Stress tests allow to identify the impact of large instantaneous market moves on the portfolio exposure

Stress tests are a complement to the PFE, but not a replacement of it!

Currently there is not a stress test limit framework in place!

Stress tests can be used for:

Visualisation of the trade/ portfolio sensitivity and risk drivers identification

Offsetting trade recommendations Comparison against limits/ appetite as a complement to the standard

PFE Communication with external clients (clients, regulators)

33


Management


Measurement




6.Stress Tests


Types of Stress Tests

Type of Scenario Pros Cons

HistoricalEasy to designEasy to explainExplicitly includes correlation

Portfolio composition may be different

Missing risk factors*

Single factorReadily available in cEISEasy to understand

Ignores correlations / multi-factor effects

Hard to compare against limit/appetite

Expected / Economic

Usually more relevant than historical

Useful for capital impact planning and bank-wide aggregation

Not readily available Not flexible and can be

misleading at counterparty level

Constructed

Scenarios “custom” made for each portfolio

All sensitivities available, useful for custom analysis

Scenario may not be the economically most relevant

Expensive, less frequent

34

1. Introduction to

Exposure Management


Measurement


Products

4. Risk Reducing

Techniques

5. Stress Tests

* For example: CDS did not exist in 1994, so credit spreads were not included as a risk factor into the analysis.


CRM Derivatives Stress Testing


Management


Measurement

3.Simple Derivative

Products

4.Risk Reducing

Techniques

5.Stress Tests

Most stress tests currently are run by EMG or are system-generated:

1.Historical scenario: EMG: designed/ custom scenarios run on an ad hoc basis

2.Single-factor stress: cEIS: default scenarios run daily

3.Expected scenario: MRM: Global Downturn Scenario as part of quarterly capital stress;

EMG: ad hoc on request (e.g. EUR/USD parity or Greece restructuring scenarios run in 2010)

4.Constructed scenario: EMG: monthly as part of global stress test released to each credit team, available

as Excel version and in dbState

35


Stress Test: Example (1)

Suppose an interest rate swap portfolio has the following stress graph:

36


Management


Measurement



5.Stress Tests



Conclusions from the graph:

1. The portfolio is sensitive to rising EUR interest rates

2. Assuming an instantaneous increase by 100 bps, the CCE will increase from EUR 23 mn to EUR 45 mn

3. The CCE limit will be breached if the EUR interest rates rise by about 130 bps

An offsetting trade would be: DB receives fixed and pays floating on EUR 150 mn up to 10 years.

37


Management


Measurement



5.Stress Tests



With the recommended trade the stress graph changes to:

38


Management


Measurement



5. Stress Tests

IMPORTANT NOTES WHEN WORKING WITH SCREENSHOW'S PRINTING INSTRUCTIONS In order to print correctly,...

Documents

Transcript of IMPORTANT NOTES WHEN WORKING WITH SCREENSHOW'S PRINTING INSTRUCTIONS In order to print correctly,...