derivatives
Judging Default Risk
Bloomberg’s counterparty valuation adjustment lets you assess and manage credit risk for
interest-rate swaps. Here’s an overview of the calculation. By HARVEY STEIN and KIN PONG LEE
value measurement accounting rule issued by the
Financial Accounting Standards Board, says that
fair value should reflect credit risk.
Here’s an overview of counterparty risk and an
outline of Bloomberg’s counterparty valuation
adjustment calculation for interest-rate swaps,
which are contracts under which two parties ex-
change streams of payments, typically one at a
fixed rate of interest on a notional amount for an-
other at a floating rate.
Counterparty risk, which is also called credit
risk or default risk, is an investor’s potential loss (if
any) if the counterparty were to default. If an in-
vestor is “long” a bond—owns it, that is—then the
O
exposure is to the bond issuer. The loss is the value
Counterparty risk ver-the-counter derivatives remain of the bond minus the amount that would be re-
Type CVA <Go> to calcu- one of the largest parts of the finan- covered by the investor. If the investor is “short”
late the adjustment to the
value of a swap because
cial markets despite the upheavals of the bond, either having issued it or having laid off
of the risk of a counter- 2008. The total outstanding notional its risk, then there is no counterparty exposure.
party defaulting. value of such contracts was $592 trillion in De- It’s the counterparty that bears the risk of default.
cember 2008, according to the Bank for Interna- The immediate exposure on an uncovered
tional Settlements. That total, 70 percent of swap is different. With a swap, an investor is si-
which was interest-rate derivatives, represented a multaneously long the receiving leg and short the
decline of 13 percent from the peak of $684 tril- paying leg. At times, the swap contract can be an
lion in June 2008. Yet in terms of gross market asset and thus exposed to counterparty default. At
value, or the cost to replace the outstanding con- other times, it can be a liability and therefore cre-
tracts, the December figure of $34 trillion was the ate no counterparty exposure.
highest ever. It was 70 percent higher than June’s
$20 trillion value. another difference between bond and swap
The collapse of Lehman Brothers Holdings exposure is in recovery. With bonds, investors
Inc. in September 2008 and the resulting market typically recover a percentage of the principal of
turmoil prompted re-evaluations of investment a defaulted instrument. The remaining interest
practices, regulations and accounting standards. payments of the bond are lost. With a swap—as
Many investors and traders have been trying to per the International Swaps and Derivatives As-
work some reckoning of counterparty risk into sociation’s master agreement—recovery is on
their trading and risk management. Regulators the market value of the swap. That value is based
have been pushing for increased use of clearing on both principal and interest payments. (A fur-
houses. Accounting boards have been refining ther difference between bond and swap counter-
fair market valuation, placing more emphasis on party exposure is that swap exposure is often
counterparty risk. From May to September, the modified by other contracts such as netting
International Accounting Standards Board
sought comments on counterparty risk calcula-
tion methodologies as part of its fair value mea-
surement project. In addition, FAS 157, the fair
152
bloomberg markets December 2009
agreements or the ISDA credit support annex.)
Exposure to default is quantified by the so-
called counterparty valuation adjustment. The
counterparty valuation adjustment is the
amount an instrument’s value is reduced be-
cause of default risk. It’s the difference between
the price of the instrument and what the price
would be if the counterparty were risk free.
The new Counterparty Valuation Adjustment
(CVA) function lets you calculate that number
for an interest-rate swap. First, either type IRDL
<Go> and load a saved swap or type SWPM <Go>,
enter the details of a new deal, click on the Ac-
tions button on the red tool bar and select Save.
Next, type CVA <Go>, enter the name of the
counterparty in the Reference field and select it Determining a swap’s exposure to counter- Exposure
in the list of matching reference entities. The party risk requires figuring out three things: what Click on the Exposure tab
at the bottom of the screen
counterparty valuation adjustment is displayed the swap will be worth in the future, how likely the to display the value and
in the upper-left corner of the screen. counterparty is to default and how much would be effect of the swaptions
recovered in the event of a default. The future val- used in the calculation.
counterparty risk calculations are fairly ues of the swap can be implied from swaption
straightforward for instruments such as bonds prices. The probability of default can be calcu-
that are long only. Such counterparty valuation lated from credit-default-swap spreads for the
adjustments can be judged using models that are counterparty. CDSs, contracts used to protect
able to incorporate a discount curve shift. The against or speculate on default, pay the buyer face
shift can be used to model the default risk. value if a reference entity defaults in exchange for
For holdings that can be either long or short the underlying securities or a cash equivalent. A
such as swaps, counterparty risk calculations are commonly used swap recovery rate is 40 percent
more complicated. Such adjustments don’t de- of the market value.
pend only on interest rates and default risk. They
also depend on volatility. consider a swap whose time T risk-free value is
Consider a five-year, at-the-money, receive- V(T). Assume no collateralization and no netting
fixed interest-rate swap in a flat-interest-rate en- agreements and a fixed recovery rate of R. If the
vironment. At zero volatility, the swap will have a counterparty were to default right now and the
market value of nearly zero and thus little default swap has positive value, then the investor receives
risk. At high volatility, the swap has the potential R V(0) for the contract, effectively losing (1–R)
to be valuable in the future, in which case a default V(0). If the swap value is negative, there is no loss:
could cause a substantial loss. The investor still owes the liability. Thus, the im-
Because swaps’ recovery is based on market mediate exposure to default is
value and not principal, they also have more expo- (1–R)max(V(0),0). Similarly, if t is the time
sure than bonds to the shape of the yield curve. If of default, then the loss at that time is
the swap curve is steep, then the swap can be (1–R)max(V(t),0). The cost of this payoff is the
heavily in the money for much of its life and thus counterparty valuation adjustment for the swap;
will have more counterparty risk. it’s the cost of hedging the counterparty risk.
The fundamental difference between the calcu- The quantity max(V(T),0) is the payoff of a
lations for swaps and those for bonds is that call option to purchase the swap at time T. Tak-
swaps can be assets or liabilities. When they are li- ing expectations with respect to the risk-neutral
abilities, there’s no counterparty risk. Taking that
into account requires the introduction of swap-
tions, or contracts that grant the right but not the
obligation to enter into a swap.
153
December 2009 bloomberg markets
derivatives
measure for the money market account (B(T)), zero-volatility version of the counterparty valua-
we see that the value of the counterparty valua- tion adjustment. For swaps that are heavily in the
tion adjustment is given by: money, the approach can give a rough idea of the
CVA. The volatility accounts for about 15 to 20 per-
[
E (1–R)
max (V(t),0)
B(t) ] cent of the counterparty valuation adjustment.
If any of the relevant swaptions are out of the
[[
money, or the swaptions are close enough to at the
= (1–R) E E
max (V(T),0)
B(T)
| T=t . ]] money that the volatility plays a larger role, then
this approximation can go seriously wrong, though.
If default is assumed to be independent of in- The errors can even happen for in-the-money
terest rates, then E[max(V(T),0)/B(T)|T= t ] is swaps, if the curve is sufficiently steep. For an at-
the current value of the call option to purchase the-money swap, the discount curve shift can un-
Cheat Sheet the contract at time T. If we denote the value of derestimate the counterparty valuation adjustment
this option by C(0,T), then we can write the coun- by as much as 60 percent. The error would be even
Type DOCS #2054933
<Go> 1 <Go> to terparty valuation adjustment as: greater in a flat interest rate environment.
download a user guide For an out-of-the-money swap, the discount-
for the CVA function. (1–R)E[C(0, t)] = (1–R) C(0,t)P(t)dt, curve-shift approximation cannot be used at all. It
t will cause an increase in the value of the swap, not
where P(t) is the default probability density func- an increase in the counterparty valuation adjust-
tion. The value of the tail, C(0,t), differs from the ment. The same holds for pay-fixed swaps in the
usual value of a swaption with exercise time t in typical interest rate environment. For example,
that in the swaption the first coupon is prorated, switching from receive-fixed to pay-fixed on a
whereas in the option to enter into the tail, the swap would make all the discount-curve-shift val-
loss is of the entire first coupon. ues negative.
The difference in forward values has a similar The financial crisis of 2008 highlighted the im-
impact on the value of the corresponding options. portance of assessing counterparty credit risk. The
Again, while the swaption values are relatively counterparty valuation adjustment for a bond or
smooth as a function of maturity, the option to other securities that are long only can be calculated
enter into the tail of the swap jumps as cash flow by using curve shifts. For securities that combine
dates are passed. Volatility has a large impact on long and short positions such as interest rate
the overall exposure. swaps, though, discount curve shifts are of limited
use. In such cases, calculations must take volatility
to calculate the counterparty valuation adjust- into account. The appropriate way to compute the
ment for a swap, we approximate the above integral CVA for an interest rate swap in essence consists of
by a sum. Because default probabilities and option combining appropriately adjusted swaption prices
prices are relatively linear between cash flows, we with default rates derived from CDS spreads. To
can get good approximations if we use the mid- download a more detailed explanation of the
point of the interval for the option exercise and Bloomberg counterparty risk adjustment calcula-
take care to adjust for the difference between swap- tion, click on the White Paper button on the red
tions and options to enter into the tail of the swap. tool bar in the CVA function. ≤
The difference between the swaptions and the
tail options can be accounted for by adjusting vola- Harvey Stein is head of counterparty and credit risk in
tilities, strikes and forward rates. To see this, click the Bloomberg R&D department in New York.
on the Exposure tab at the bottom of the CVA hjstein@[Link]
Kin Pong Lee is on the staff of the quantitative finance
screen. As cash flows are paid, there are jumps in R&D group in New York.
exposure that don’t exist for swaptions. klee65@[Link]
It’s interesting to compare the counterparty val- Press <Help> twice to send a question to the Bloomberg
uation adjustment calculation with the common Analytics help desk.
practice of shifting the discount curve to approxi-
mate the CVA. When all the corresponding swap-
tions are in the money, this corresponds to the
154
bloomberg markets December 2009