Basel III CVA and VaR Capital Charge
CVA Overview
Basel III introduced a new CVA capital charge from 1st January 2013. The measure applies to all counterparty exposures arising from OTC derivatives with the exception of Central Couterparties and Securities Financing Transactions (Repos). The measure for firms with specific VaR approval, the charge will be using the market risk VaR model and its aggregation will be done by simple sum with no offset or diversification allowed.
CVA Var must be able to be calculated under Stressed and normal VaR timeseries with the multiplier being applied to both MR and CVA VaR charges. The inputs to the CVA equation are bond-equivalent positions. Eligible credit risk hedgs from dedicated CVA management portfolios can also be included, if this happens these position can be excluded from MR VaR. Likewise, MR CVA hedges may not be included in CVA VaR since they are inputs to the MR VaR.
The CVA VaR only includes Credit Spread Risk: FX and IR risks are not included and firms are exempt from calculating IRC in the CVA VaR model.
The regulatory rules
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CVA charge applies to all OTC derivatives except CCP and SFTs unless the latter is considered to generate material CVA loss.
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It defines the exposure calculations. CVA VaR includes only credit spread risks, not market risks. It defines inputs including LGD market and EE. Proxy rules are applicable where market data is unavailable.
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It defines the exposure calculations for parallel and tenor-based credit spread shifts. The short cut method exposures should be included using constant EE profile out to the max of half the longest maturity in the netting set and the notional average maturity. CEM exposures can also be included as per the shortcut method but using EAD in the place of EE. IF the VaR model does not appropriately reflect the credit spread risk of the counterparty, the STD approach must be used rather than the CVA VaR.
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CVA VaR includes specific and general credit risk spreads risks. Stressed VaR must also be calculated uing the stressed exposur profiles from the worst 1 yr period in the past 3 years. The capital charge excluding IRC is equal t0:
CVA VaR+CVA Stressed VaR x Multiplier
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There is no offset between the CVA charge and any other charges
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Only hedges held to mitigate the CVA risk may be included in the calculation. CDS held elsewhere are not eligible.
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Eligible hedges are SN CDS, SN Contingent CDS, Index CDS and other equivalent instruments referencing the counterparty directly. For Index CDS, basis risk vs SN CDS must be included or only 50% of index hedges count. Tranches and NTDs are not eligible. Eligible hedges must be removed from market risk VaR.
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Details of STD rules capital calculation
The CVA VaR Charge must be added to the IMM charge. If CVA VaR captures rating migration risk, the IMM charge may be calculated using Maturity of 1.
Comprehensive Capital Charge formula
Capital Charge = Multiplier*(VaR+Stressed VaR+CVA VaR+Stressed CVA VaR)+IRC+CCR
where:
- Multiplier includes any uplift for 5 years backtesting exceptions.
- VaR+SVaR reflecting market risk, calculated with 99% confidence, 10 day holding period using 2 yr of exponentially weighted data and the using the worst one year period during the financial crisis.
- CVA VaR and CVA Stressed VaR refelcting the counterparty spread risk, using the same model but with bond equivalent CS01 for OTC derivatives and dedicated CVA Hedges. CVA stressed VaR is based on stressed inputs (using worst one year in the past 3)
- IRC refelcting the issuer migration and default risk, based on 99.9% confidence, 1 year default and migration risk charge for TB positions.
- CCR reflecting the counterparty default and migration risk (Max EPE and Stressd EPE)
CVA VaR Calculation Steps
CVA VaR approach requires two sets of models: 1) to calculate the EE and Stressed EE, 2) to calculate CVA VaR
Various EE models are already in place, as they are used to calculate the CCR EAD inputs to the credit risk charge. The Stressed EE models will have to be built and calibrated to the worst one year period in the most recent 3 years. The two model approach also applies to the “what if” functionality with hypothetical positions to be converted into EE, then CS01 and VaR.
CVA Inputs required
Reg Approach | ||
IMM | Inputs | Inputs if LGD in unavailable |
EE by tenor | Rating | |
Stressed EE by tenor | Industry | |
Maturity | Region | |
Credit Spreads | ||
Market implied LGD | ||
Discount Rate | ||
CEM | EAD | Rating |
Maturity | Industry | |
Credit Spreads | Region | |
Market implied LGD | ||
Discount Rate |
CVA VaR Calculation
Calculation | Features |
Main Approach | 99%, 10d calibration |
Norm and Stressed EE | |
Include Multiplier | |
Only allowed for prods with specific risk approvals | |
No IRC | |
CVA Specific Features | Uses reg defined exposure calculation |
no Internal CS01 | |
SvaR based on stressed parameters, exposure calibrations | |
Must capture single name vs index basis or 50% of indices eligible. | |
VaR includes only credit spreads risk. No IR, FX, EQ… | |
Separate calculation to MR VaR, no hedging or diversification | |
If rating migration is not captured, no need for maturity adj for EPE |
CVA VaR vs MR VaR: similarities and differences
MR VaR | CVA VaR | |
Product Coverage | All TB MR positions | Exposures from OTC deriv in BB and TB |
Eligible Hedges in CVA desk | ||
Sensitivities | All relevant ones | Just CR spread risk |
Generated by one only source (FO) | Exposures using reg bond equivalent with hedges using internal approach | |
Hist observation period | VaR uses 2 yrs of exponentially weighted data | Same as MR VaR |
SvaR use worst year during crisis | SCVA VaR inputs based on 1 yr periodin past 3 years | |
Specific Risk Req | STD covering explaining Hist Price variation, robustness to a financial crisis | Same as MR VaR + Single name vs Index risk |
Concentration risk and event risk |
CVA VaR Hedge Portfolios
Credit hedges: Are only designated hedge portfolios not cds held elsewhere. Eligibility restricted to single name CDS, Single name cont CDS. Eligible CDS must be removed from MR VaR
Market Risk Hedges: MR (IR, FX,…) hedges are not eligible. MR hedges will be included in the MR VaR instead