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Algorithmics Advocates Active Management of Counterparty Credit Risk with CVA in New White Paper

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In its latest white paper on counterparty credit risk, Algorithmics outlines several recommendations and milestones for any institution interested in actively managing its counterparty credit risk (CCR) using credit valuation adjustment (CVA) to price the counterparty risk.

Since the crisis, there has been a shift from passive to active management of counterparty credit risk that requires increasingly accurate and more frequent CVA calculations – from daily, to intraday to real-time. Many institutions have begun to centralise the quantification, pricing and management of their counterparty credit risk by establishing an internal CVA trading desk that quantifies CCR for individual business lines and uses the price measure of CVA to actively manage this risk across the entire institution.

Bob Boettcher, senior director, product strategy, Algorithmics, said: “Many financial institutions are now looking to actively build up their CVA capabilities to accurately price and manage counterparty credit risk across all their business lines. We see CVA desks in the front office becoming standard practice for banks and other large OTC derivatives users.

“However, rigorous calculation of CVA is non-trivial, even on a periodic basis. Algorithmics believes that the key to running a successful CVA desk is to find the right balance between risk taking and active hedging. Once institutions have this balance and an effective mechanism to compute incremental CVA at deal time, they can use accurately priced CVA to competitive advantage in their trading businesses.”

Algorithmics’ latest white paper, “Towards active management of counterparty credit risk with CVA”, explores best practices and practical challenges in counterparty credit risk management through proper calculation of CVA, and builds on the white paper published in March 2010 on emerging CVA practices, “Credit Value Adjustment: The changing environment for pricing and managing counterparty risk”.

Key recommendations for actively managing counterparty credit risk with CVA

  • · Reaping the most benefits requires an accurate measure of CVA that:
  • Accounts for all trades with a single counterparty, and properly models bi-lateral netting and collateral agreements including the margin period of risk
  • Generates risk-neutral scenarios across all risk factors
  • Incorporates wrong and right way correlations in the CVA measure
  • · Having a ”CVA desk” team is an emerging standard that will:
  • Centralise the quantification, pricing and management of counterparty credit risk that covers all asset classes and business lines
  • Provide more competitive pricing, increase transaction volumes with beneficial counterparties
  • Hedge CVA to avoid dramatic swings in profit and loss, and build an understanding of the residual risks of this hedging.

Ben De Prisco, senior vice president of research and financial engineering at Algorithmics concluded: “CVA modeling approaches that take short cuts or make inappropriate assumptions can have a dramatic impact on results and undermine the potential benefits for firms. Our consistent and systematic approach to CVA leverages the proven structure of our integrated market and credit risk solution, and will provide financial institutions with the foundation they need to enhance their pricing practices and improve their capital management.”

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