The New Post-crisis Landscape of Derivatives and Fixed Income Activity under Regulatory Constraints on Credit risk, Liquidity risk, and Counterparty risk.
Nicole El Karoui, LPMA-UPMC, Paris
The motivation for this course is to update academic community on the deep transformation after the financial 2008- crisis in the world of interest rates, and credit derivatives induced by the regulation. Liquidity risk, credit risk, counterparty risk have become more bulky over the recent years, maybe than the market risk, given the identified lack of transparence in the OTC Market.
These risks can be mitigated by the way trade and post-trade functions are structured. At trading level, risks can be reduced by improving operational efficiency, e.g. ensuring electronic trade execution, affirmation and confirmation.This would have the effect of making OTC trade execution more similar to the way transactions are handled on-exchange.
One way is to impose collateral and margin requirements. In the bilateral clearing, the two counterparties most often have collateral agreements in place that provide for regular monitoring of how the value of the contract evolves so as to manage their respective credit exposures to each other. In the Central Counter-party (CCP)clearing, the CCP acts as a counterparty to each side of a transaction. It makes collateral management simpler, as it is the CCP that collects and manages collateral.
Special attention is dedicated to reduce credit risks notably in Credit Default Swap (CDS) market, since CDS are particularly vulnerable on many respects. The risk they cover-the credit risk- is not immediately observable but requires specific information about the borrower, which typically only banks have had. Assessing the risk remains difficult, and amplified by the fact that the potential obligations that come with them are extreme.
It is of crucial importance in a derivative business at a aggregated level, to (i) measure counterparty exposure, (ii) compute capital requirements, and (iii) hedge counterparty risk. Measuring counterparty exposure is important for setting limits on the amount of business a firm is prepared to do with a given counterparty; hedging it gives a possibility of mitigating it and transferring risk; and from a regulatory perspective there is significant pressure on financial institutions to have the capability of producing accurate risk measures to compute capital. In addition, computing counterparty exposure can also give insights into prices of complex products in potential future scenarios.The Risk Control, function attracting relatively limited attention in the past, is now becoming a central activity of all major financial institutions, requiring significant resources from all parties.
The aim of the course is to provide a bridge between old and new practices including counterparty risk in fixed income and credit derivatives market, first at the level of the bilateral contract, second at the aggregated level. In particular, we try to make a rigorous formulation of the different problems
The first part is dedicated to the basic foundations of the interest rates derivatives in a perfect market, by making a clear distinction between the different notions of funding, risk-free rate, bond, and also the notions of forward curve and discounting curve. As a consequence, we deduced the standard HJM framework
on interest rates dynamics and the notion of forward neutral probability measure. In regard, we describe the standard contracts as forward or future contracts, swaps, and the associated derivatives.
The second part is an (non standard) introduction of the default derivative world, where the basic contact is the CDS, without specific mathematical tools. Default spreads and other similar quantities appear naturally. A general framework is then introduced. Examples of affine models. These tools are necessary to model the liquidity risk in the interbank market, and the multi-discounting curves. Different examples are developed.
Pricing with collateral: some typical non-linear backward stochastic equation for pricing. Right-way/Wrong-way risk;
Hedging and Managing counterparty risk; aggregation and risk mitigation; stress testing.
Cesari, G., Aquilina, J., Charpillon, N., Filipovic, Z., Lee, G., & Manda, I. (2009). Modelling, pricing, and hedging counterparty credit exposure: A technical guide. Springer Science & Business Media.
Grbac, Z., & Runggaldier, W. J. (2015). Interest Rate Modeling: Post-Crisis Challenges and Approaches.
Henrard, M. (2013). Multi-curves framework with stochastic spread: A coherent approach to STIR futures and their options. OpenGamma Quantitative Research, (11).