Gaining From Your Own Default

Transcription

1 Ganng From Your Own Defaul Jon Gregory Jon Gregory Quan ongress US, 14 h July 2010 page 1

2 Regulaon s Easy () Wha don lke as a regulaor? Dfferen nsuons valung asses dfferenly nsuon A rades a dervave wh nsuon B and hey boh book a prof! nsuons makng profs based on mark-o-model By he me we realze our model was wrong hen bonuses have been pad Balance shees no beng a zero sum game For example, f a frm ssues a bond do hey mark s par value as a lably or s marke value? Jon Gregory (jon@ofranng.com), Quan ongress US, 14 h July 2010 page 2

3 Regulaon s Easy () How o solve he problems? Dfferen nsuons valung asses dfferenly Mark-o-marke (far value accounng) nsuons makng profs based on mark-o-model Mark-o-marke Balance shees no beng a zero sum game Mark-o-marke (of own lables on balance shee) Jon Gregory (jon@ofranng.com), Quan ongress US, 14 h July 2010 page 3

4 Prcng Lables Wh Your Own red Rsk Suppose a frm ssues a bond (par value $100) wh a reasury lke coupon The marke wll only pay $95 for hs bond due o he frm s cred rsk Asses Lables Asses Lables $95 cash $95 bond $95 cash $100 bond Jon Gregory (jon@ofranng.com), Quan ongress US, 14 h July 2010 page 4

5 Ganng from Your Own Defaul The frm s cred spread wdens The marke prce of he bond s now $90 Prof of $5 Asses Lables $95 cash $90 bond 18% of pre-ax ncome for JPM, MS, BoA and GS n second quarer Jon Gregory (jon@ofranng.com), Quan ongress US, 14h July 2010 page 5

6 VA (red Value Adjusmen) VA s he prce of counerpary rsk (expeced loss) and s a cos Rsky Dervave Dervave- VA rucal o be able o separae valuaon of dervaves and her VA VA ( ) (1 ) EE( u) dpd ( u) T Percenage recovery value Expeced exposure ncludng dscounng (how much we expec o lose) Defaul probably (how lkely s counerpary o defaul a hs me) Jon Gregory (jon@ofranng.com), Quan ongress US, 14 h July 2010 page 6

7 Bu VA s Very omplex VA represens an opon on an underlyng dervave VA calculaon always harder han prcng he dervave self Need he defaul probably (and recovery rae) of he counerpary Ofen marke mpled probables are no known (no DS marke) Dervaves are subjec o neng agreemens Need o prce all oher rades wh hs counerpary as well as rade n queson All correlaons (same asse class, cross-asse class mus be known) Wrong way rsk Lnkage beween defaul probably and exposure a defaul ollaeral agreemens, break clauses ec Jon Gregory (jon@ofranng.com), Quan ongress US, 14 h July 2010 page 7

8 VA Rsk-Neural or No? Acuaral onssen wh loan book managemen nsurance company syle approach s easer No hedgng Rsk-neural onssen wh dervaves valuaon Bu radng funcon for VA s very dffcul o run Hedgng s exremely dffcul or mpossble Regulaors favour he rsk-neural (mark-o-marke) approach Bu recen problems wh hedgng n he urbulen Eurozone possbly queson hs And loans are no reaed hs way (a dervave s essenally an exoc loan) Jon Gregory (jon@ofranng.com), Quan ongress US, 14 h July 2010 page 8

9 Unlaeral VA n he Old Days red Rang red spread (bps) Bank Aa1/AA orporae A3/A Bank has no defaul rsk Bank charges corporae unlaeral VA f corporae asks for banks defaul probably o be aken no accoun, hey ge laughed a No VA charges n nerbank marke (collaeralsed, banks won defaul) When bank cred qualy deeroraes, marke becomes grdlocked Jon Gregory (jon@ofranng.com), Quan ongress US, 14 h July 2010 page 9

10 Blaeral VA Wh unlaeral VA, everyone wans o charge each oher for counerpary rsk Soluon : Blaeral VA Takng no accoun an nsuon s own defaul probably When defaul happens, nsuon ( we ) pay only a fracon of negave MM of need posons wh each counerpary (negave exposure) Bu we sll receve n full wha we are owed (exposure) Hence we may gan where we have lables Jon Gregory (jon@ofranng.com), Quan ongress US, 14 h July 2010 page 10

11 Prcng Blaeral ounerpary Rsk Blaeral VA consders also an nsuons own defaul (hs formula assumes ndependen of defauls) BVA( ) (1 (1 ) Own percenage recovery value T ) T EE( u) 1 PD Expeced exposure NEE( u) 1 PD Negave expeced exposure ( u) Probably we haven ye defauled ( u) Probably counerpary hasn ye defauled dpd dpd ( u) Probably counerpary defauls ( u) Probably we defaul VA DVA Jon Gregory (jon@ofranng.com), Quan ongress US, 14 h July 2010 page 11

12 ompung he Blaeral Prce Blaeral VA Example ase A : ounerpary 250 bps DS, nsuon 500 bps DS, EE < NEE ase B : ounerpary 500 bps DS, nsuon 250 bps DS, EE > NEE EE (ase A) NEE (ase A) EE (ase B) NEE (ase B) 20% 15% Exposure 10% 5% 0% -5% ase A ase B VA 1.235% 3.480% BVA % 1.967% -10% -15% -20% Tme (years) Jon Gregory (jon@ofranng.com), Quan ongress US, 14 h July 2010 page 12

13 Jon Gregory Quan ongress US, 14 h July 2010 page 13 Defaul orrelaon Gaussan copula approach can be used o gve smple racable correlaon beween our own defaul and ha of our counerpary Jus requres bvarae Gaussan dsrbuon funcon For example, probably our counerpary defauls n an nerval bu we don ) ( ; ) (, ) ( ; ) (, ) ( ),, ( ),, ( ), ],, [ ( d d Q Q Q Q Q Q Q Q

14 mpac of orrelaon on BVA ase B from prevous example ounerpary 500 bps DS, nsuon 250 bps DS, EE > NEE Blaeral VA 4.0% 3.5% 3.0% 2.5% 2.0% 1.5% 1.0% 0.5% 0.0% 0% 20% 40% 60% 80% 100% orrelaon Base ase VA 3.480% BVA 1.967% Jon Gregory (jon@ofranng.com), Quan ongress US, 14 h July 2010 page 14

15 mpac of DVA Blaeral VA EPE ounerpary spread - ENE nsuon spread VA DVA Ne adjusmen o dervaves book Toal VA Toal DVA Jon Gregory (jon@ofranng.com), Quan ongress US, 14 h July 2010 page 15

16 Does Blaeral VA Make Sense? Blaeral VA has been wdely adoped Many banks base VA on her own defaul Accounancy rules requre hs (e.g. FAS 157) Blaeral VA has some poenally unpleasan feaures Toal amoun of VA n he marke sums o zero Rsky value may exceed rsk-free value Neng and collaeral may ncrease VA Hedgng hs componen s problemac How o monese blaeral VA o jusfy payng for counerpary rsk? Jon Gregory (jon@ofranng.com), Quan ongress US, 14 h July 2010 page 16

17 How o Realse DVA Go bankrup Usually no a popular choce Unwnds or novaons An nsuon may realse a DVA gan f a rade s unwound n he fuure (e.g. banks unwndng ransacons wh monolnes) Fundng argumens EE represens a long-erm recevable, NEE represens a long-erm payable Hedgng DVA much harder o hedge han VA - canno sell DS proecon on yourself! An nsuon mgh aemp o realse an ncreasng DVA by buyng back her own deb bu hs canno be a dynamc process and an nsuon may sruggle o do hs f her cred qualy s declnng Jon Gregory (jon@ofranng.com), Quan ongress US, 14 h July 2010 page 17

18 Fundng oss and VA / DVA Measure Exposure Defaul probably Defaul VA EPE ounerpary cred spread DVA ENE Own cred spread Fundng Fundng cos EPE Own fundng spread Fundng benef ENE Own fundng spread Double counng Jon Gregory (jon@ofranng.com), Quan ongress US, 14 h July 2010 page 18

19 Double ounng of Fundng VA of a sngle cashflow VA e rt (r X )T E e 1τ e X T e X T T X = Fundng spread Fundng cos Defaul rsk DVA DVA e rt E e e X (r X T e )T 1 X τ T T e rt e 2 X T Fundng gan Defaul rsk (own) Jon Gregory (jon@ofranng.com), Quan ongress US, 14 h July 2010 page 19

20 Fundng oss Under Unlaeral VA Measure Exposure Defaul probably Defaul VA EPE ounerpary cred spread DVA - - Fundng Fundng cos EPE Own asse fundng spread Fundng benef ENE Own lably fundng spread Jon Gregory (jon@ofranng.com), Quan ongress US, 14 h July 2010 page 20

21 Fundng oss Under Blaeral VA Measure Exposure Defaul probably Defaul VA EPE ounerpary cred spread DVA ENE Own cred spread Fundng Fundng cos EPE Own asse fundng spread Fundng benef - - Jon Gregory (jon@ofranng.com), Quan ongress US, 14 h July 2010 page 21

22 Should you use DVA? On he one hand, frms need o use DVA Reduces cred charges Lkely ha boh counerpares o a rade wll agree on he cred charge Reduces volaly of VA desk s book Reduces hedgng coss On he oher hand Has some unpleasan feaures Does no encourage good pracces for a VA desk For example, a frm gong o defaul wll need o sell more and more DS proecon (and more and more volaly) Jon Gregory (jon@ofranng.com), Quan ongress US, 14 h July 2010 page 22

23 Soluons o he Problem Do no nven regulaon whou undersandng he lkely mpac n parcular, he mprecson of mark-o-marke n some markes wh he relaed need for banks o hedge her rsk Ban DVA looks good n normal markes and causes problems n urbulen ones Ths means everyone suffers a cos for every rade wh counerpary rsk? Tha s lfe The over-collaeralsaon ha regulaors wan (cenral counerpares) s he same sor of hng as everyone havng a VA charge f you hnk your deb s cheap hen buy back and make money Properly undersand he lnk beween prcng of dervaves and fundng OS vs LBOR dscounng of collaeralsed rades Fundng coss and benefs of non-collaeralsed rades Jon Gregory (jon@ofranng.com), Quan ongress US, 14 h July 2010 page 23

24 Jon Gregory Quan ongress US, 14 h July 2010 page 24