Credit Support Annex Research Articles

The Collateral-Linked Currency Forward (CLCF) Contract: Blockchain-Enabled OTC Currency Forward Market Infrastructure

We eliminate the primary source of uncompensated risk from trading in one of the largest sectors of the global financial markets. Market infrastructure enhancements are achieved in the foreign exchange (FX) forward contract market by integrating distributed ledger technology (DLT) into the creation of collateral-linked contracts for currency forwards (CLCF). Specifically, we deploy DLT with embedded automation as the shared platform for bilateral FX forward contracts, including operational provisions of International Swaps and Derivatives Association and Credit Support Annex agreements. Through automation, we link the economics of the currency forward contract and the price-volatility-induced counterparty exposures, bringing intraday counterparty risk to within mutually acceptable ranges. The essential benefits of the over-the-counter market structure are preserved because CLCF contracts remain bilateral to allow for customized terms and conditions between market participants. Reduced concentration risk is also preserved because there is no central counterparty or central clearing organization into which all risks are pooled. As a result, liquidity is enhanced and risk is reduced in the FX forward contract market.

An Overview of Collateralization Fundamentals & the ISDA Credit Support Annex

In this paper we discuss the continued transition of financial markets towards trade standardization and the clearing of transactions, outlining the role of central clearing counterparties CCPs in reducing systemic and idiosyncratic risk. We contrast this with a discussion on bespoke non-cleared bilateral trading, the associated credit risk management process and the charging of credit valuation adjustments termed collectively as XVA adjustments, with the principal credit valuation adjustment termed CVA. The majority of trading counterparties require collateral to be posted to cover bilateral trading positions and have extensive legal documentation in place to govern the collateral calculation and transfer process, of which the ISDA Credit Support Annex or CSA agreement is the most common and market standard. We discuss both the collateral posting process in detail and outline all the main important terminology and terms outlined in the ISDA CSA. Finally we outline trading features that require special considerations, namely trade break-clauses and physical and cash settlement features.

FX Forward Invariance & Discounting with CSA Collateral

In what follows we outline briefly the Credit Support Annex and how it impacts securities pricing. We then proceed to discuss synthetic forward rate calculation and the FX forward invariance relationship from which we show how to calculate CSA collateral adjusted discount factors using GBP curves with a EUR CSA collateral as an illustration.

A New Model for Pricing Collateralized Financial Derivatives

In recent years, collateralization of derivative contracts has extended from the standard mark-to-market and margining systems for exchange-traded contracts to the over-the-counter (OTC) market. This expansion of credit enhancement in OTC contracts has been underway at least since the 1990s, but it was formalized in the Dodd–Frank Act. The great majority of derivatives are now subject to collateralization requirements that are specified in a Credit Support Annex to the counterparties’ ISDA agreement. Derivatives counterparties must make a credit value adjustment (CVA) to the value of a contract on their books to account for the effect of counterparty credit risk. But the pricing models generally do not take the interaction between market prices and collateral values into account. This article develops a valuation approach that incorporates the counterparty’s credit quality and the effect of collateral, given market practices on how collateral is handled both under normal conditions and in a bankruptcy. Empirical comparison of the pricing of matched swaps with and without collateral support shows that the market does adjust for the mitigation of counterparty risk by the use of collateral, and that both factors are important. <b>TOPICS:</b>Counterparty risk, legal/regulatory/public policy, risk management

Rethinking the margin period of risk

We describe a new framework for modeling collateralized exposure under an International Swaps and Derivatives Association Master Agreement with a Credit Support Annex. The proposed model captures the legal and operational aspects of default in considerably greater detail than the models currently used by most practitioners while remaining fully tractable and computationally feasible. Specifically, it considers the remedies and suspension rights available within these legal agreements, the firm's policies in availing itself of these rights and the typical time it takes to exercise them in practice. The inclusion of these effects is shown to produce significantly higher credit exposure for representative portfolios than do the current models. The increase is especially pronounced when the dynamic initial margin is also present.

Rethinking Margin Period of Risk

We describe a new framework for collateralized exposure modelling under an ISDA Master Agreement with a Credit Support Annex. The proposed model captures legal and operational aspects of default in considerably greater detail than models currently used by most practitioners, while remaining fully tractable and computationally feasible. Specifically, it considers the remedies and suspension rights available within these legal agreements; the firm's policies in availing itself of these rights; and the typical time it takes to exercise them in practice. The inclusion of these effects is shown to produce significantly higher credit exposure for representative portfolios compared to the currently used models. The increase is especially pronounced when dynamic initial margin is also present.

A note on discounting and funding value adjustments for derivatives

In this paper, valuation of a derivative partially collateralized in a specific foreign currency defined in its credit support annex traded between default-free counterparties is studied. Two pricing approaches — by hedging and by expectation — are presented to obtain similar valuation formulae which are equivalent under certain conditions. Our findings show that the current marking-to-market value of such a derivative consists of three components: the price of the perfectly collateralized derivative (a.k.a. the price by collateral rate discounting), the value adjustment due to different funding spreads between the payoff currency and the collateral currency, and the value adjustment due to funding requirements of the uncollateralized exposure. These results generalize previous works on discounting for fully collateralized derivatives and on funding value adjustments for partially collateralized or uncollateralized derivatives.

CSA Discounting: Impacts on Pricing and Risk of Commodity Derivatives

The global financial crisis of 2007-2008 caused market practitioners to reassess the way in which financial derivative contracts had been priced during the preceding thirty years. The purpose of this paper is to examine the evolving practice of pricing and hedging commodity derivative contracts according to the terms of the Credit Support Annex (CSA). Using a series of case studies, we price crude oil swaps and Asian options in the pre-crisis, peak-crisis, post-crisis and recent market environments under two different frameworks: LIBOR discounting and CSA discounting (also referred to in a less general form as “OIS discounting”, which incorporates nearly risk-free interest rates). We also compute the widely used first-order and second-order Greek sensitivities. In each market environment, we shift the forward prices and implied volatilities crude oil and re-compute the trades’ valuation and Greek sensitivities at each incremental increase or decrease in price or implied volatility. Under each discounting framework, we quantify the change in trade valuation and Greek sensitivities that results from switching from LIBOR discounting to CSA discounting. The impact on the valuation and Greek sensitivities of a swap and an Asian option as the result of adopting CSA discounting can be significant under certain market conditions. There is likely to be larger impact on directional portfolios containing transactions that hedge either consumption or production (e.g. end users). Ceteris paribus, the impact on portfolio valuation and risk is likely to be limited for market participants (e.g. banks) with hedged portfolios that contain a large number of offsetting positions. Even though we focus our analysis on crude oil derivative contracts, the results easily extend to other asset classes such as natural gas, refined products, agriculture, metals, etc.

Optimal Collateralization with Bilateral Default Risk

We consider over-the-counter (OTC) transactions with bilateral default risk, and study the optimal design of the Credit Support Annex (CSA). In a setting where agents have access to a trading technology, default penalties and collateral costs arise endogenously as a result of foregone investment opportunities. We show how the optimal CSA trades o! the costs and volatility of the collateralization procedure against the reduction in exposure to counterparty risk and expected default losses. The results are used to provide insights on the key drivers of di!erent types of collateral rules, including hedging motives, re-hypothecation of collateral, and close-out conventions.

Evaluating Double-Default Risk with a Regime Switching Hazard Rate Process and a Chaining Copula Model

Since the financial crises in 2008, the default risk of counter-parties has drawn increased attention. One way of mitigating this default risk is the so-called credit support annex (CSA). The CSA denies rules under which collateral is received -- respectively posted -- in order to protect against losses in case of the default of the counter-party. However, for credit derivatives there is still a residual risk, when the derivative's reference entity and the counter-party default at the same time. As will be outlined in due course, standard techniques known from default correlation derivatives are inappropriate to evaluate that gap risk. Hence, we will present new techniques, namely a copula model for simultaneous defaults and a regime-switching hazard rate model to cope with that evaluation problem.

A Note on Discounting and Funding Value Adjustments for Derivatives

In this paper, valuation of a derivative partially collateralized in a specific foreign currency defined in its credit support annex traded between default-free counterparties is studied. Two pricing approaches -- by hedging and by expectation -- are presented to obtain the same valuation formulae. Our findings show that the current marking-to-market value of such a derivative consists of three components: the price of the perfectly collateralized derivative (a.k.a. price by collateral rate discounting), the value adjustment due to different funding spreads between the payoff currency and the collateral currency, and the value adjustment due to funding requirements of the uncollateralized exposure. These results generalize previous works on discounting for fully collateralized derivatives and on funding value adjustment for partially collateralized or uncollateralized derivatives.

Calculating the effect of funding costs on OTC valuation using funding valuation adjustment

The implementation of new regulations, including Dodd-Frank, MiFID II, EMIR and Basel III, is significantly increasing the cost of capital and forcing banks to re-evaluate the economics of their over-the-counter (OTC) trading businesses. Market best practice implemented by the most sophisticated banks now accurately measures all the components of a trade to analyse its profitability, including credit valuation adjustment (CVA), the cost of regulatory capital (CRC) and, most recently, funding valuation adjustment (FVA). Accurately measuring these components requires taking into account the OTC trades conducted across all desks with that counterparty, along with the collateral posted or received as part of any credit support annex (CSA). This is a significant new challenge for OTC businesses that has traditionally been siloed, often with separate front office analytics and systems. As these components span multiple trading desks, there has been a trend towards central measurement and management of these components by CVA desks with various strategies for allocating the profit/loss and risk of a trade between each trading desk and the CVA desk. FVA is the latest significant innovation in this area that captures the impact of funding and liquidity on the value of a trade. This value depends on the nature of the CSA (collateralised, uncollateralised or asymmetrical) and the net collateral posted or received.

Clean Valuation Framework for the USD Silo - An Implication for the Forthcoming Standard Credit Support Annex (SCSA)

In the forthcoming ISDA Standard Credit Support Annex (SCSA), the trades denominated in non-G5 currencies as well as those include multiple currencies are expected to be allocated to the USD silo, where the contracts are collateralized by USD cash, or a different currency with an appropriate interest rate overlay to achieve the same economic effects. In this paper, we have presented a simple generic valuation framework for the clean price under the USD silo with the the detailed procedures for the initial term structure construction. We have also shown that Cross Currency Swap (CCS) basis spread can be expressed as a difference between two swap rates.

Pricing with Standard CSA Defined by Currency Buckets

The widening of interest rate spreads have highlighted the importance of Credit Support Annex (CSA) in the valuation of derivatives, and the necessity to specify all valuation details in those CSA. Beside discussions around legacy CSA, market participants are also trying to standardize CSA for new transactions, thus defining new rules for liquid products. In this paper, we define a pricing theory where a liquid derivative is fully collateralized in a currency that only depends on the derivative at stake. We show how it can be consistent to have multiple derivatives collateralized in different currencies, and how to price and hedge other derivatives with customized collateral currencies, including convexity adjustments. On the theoretical side, we build a risk-neutral probability without the usual hypothesis that a trader can lend or borrow money at some idealized risk-free rate, with an idealized counter-party. Instead, we only use market observable rates, including tomorrow next contracts. It turns out that the usual pricing mechanics are merely unchanged, it is rather the meaning of the model that changes. We also give hints for extension to liquidity and credit impacts, that should be computed on top of a consistent model for liquid interest rates products.