Derivatives risks as costs in a one-period network model

Abstract

In counterparty credit risk complete markets, collateral and capital requirements would be indifferent to banks. The quantification by banks of market incompleteness based on various XVA metrics ([11]) has emerged as the unintended consequence of the FRTB banking reform ([26]) and of the more demanding regulatory capital requirements ([38]). The related risks are in fact reckoned today as the major risks for banks, well ahead market risk ([35, Figure 65 page 67]). The XVA metrics have been introduced and traditionally used by investment banks for pricing and collateral/capital optimization purposes. We demonstrate in this paper that they can be fruitfully used for risk management, suggesting a sound approach to regulatory requirements. We present a one-period cost-of-capital XVA setup encompassing bilateral and centrally cleared trading in a unified framework, with explicit formulas for most quantities at hand. We illustrate possible uses of this framework for running stress test exercises on financial networks with one and two clearinghouses from a clearing member's perspective or for optimizing the porting of the portfolio of a defaulted clearing member using Monte-Carlo technique with corresponding confidence errors in elliptical models. A continuous-time extension of this approach is provided in the companion paper [7].