Counterparty Risk Measures Elusive

Terry Flanagan

As the financial industry awaits regulatory changes coming with Dodd-Frank and Basel III, issues surrounding counterparty credit risk and increased cost of capital are swirling about the capital markets.

With increased regulatory pressure on financial institutions to manage counterparty credit risk, robust real-time risk analytics for credit valuation adjustment, or CVA, are now a necessity.

Although real-time risk analytics for CVA is not required under current regulations, Basel III will require that banks calculate CVA and hold capital against this measure.

CVA is typically defined as the difference between the value of a derivative, assuming the counterparty is default risk-free, and the value reflecting the default risk of the counterparty.

“One of the biggest challenges we are hearing about from the market today is the need for CVA calculations for OTC derivatives at both the aggregate and granular level,” Bob Park, chief executive of Fincad, told Markets Media. “There is the need for institutional transparency but also the ability to track risks, exposures and profitability back to the transaction or trader level.”

Fincad’s latest release of its F3 OTC derivatives pricing system addresses market needs around the effects of counterparty credit risk on valuation, whether via the impact of collateral on curve building in a multi-currency framework or through CVA.

“Under the CVA paradigm, we have seen the need to price derivatives while at the same time calculating portfolio sensitivities and allocating CVA charges back to the trader level,” said Park.

This has been challenging because CVA/PFE (Potential Future Exposure) are computationally intense. Institutions need a system that’s built to withstand some industrial strength testing and analysis.

And financial institutions are finding flexibility to price more complex or illiquid instruments a concern.

“Hedge funds are making markets in illiquid areas and need a pricing and risk solution they can trust and that they can get up and running quickly,” said Park. “A lot of the legacy systems might not be taking a modern approach to price derivatives and build curves. This has led to a lot of interest in the F3 product platform from Fincad.”

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