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Going mainstream: Next steps in the xVA journey

Written by Jon  Gregory, Independent Expert specialising in counterparty risk and xVA related projects. Jon will be speaking at Global Derivatives in May 2017, one of the sessions will be "The Next Steps in the XVA Journey". He has provided us some insight ahead of time. Read on.

Traditional derivatives pricing and valuation generally considered only the impact of cashflows. For simple transactions, this problem was always considered relatively straightforward and often simply a question of applying the correct risk-free discount factor. Valuation was only considered difficult where cashflows were themselves more complex, such as being non-linear, contingent or multidimensional. These more complex payoffs or “exotics” were difficult to value but the more vanilla equivalents were assumed to be relatively trivial.

Recent years have increasingly shown that the above assumptions do not hold, as credit risk, funding, collateral and capital have all been viewed as having a significant impact on the valuation of all derivatives. The general term “xVA” has been used to classify a variety of valuation adjustments (VAs) that consider these aforementioned factors.

The role of xVA can be represented as:

Vactual = Videal + xVA.          (1)

This allows the actual value (Vactual) to be represented as some ideal value (Videal), together with the relevant valuation adjustments. The valuation adjustments - although not strictly speaking mutually exclusive - are often defined as CVA (credit), FVA (funding), ColVA (collateral), KVA (capital) and MVA (initial margin).

There are several reasons why the above separation makes sense:

• Complexity. As suggested by the name, ܸVideal in the above representation may be a relatively simple calculation, perhaps only reflecting the valuation of the cashflows as in the traditional approach. It may also conform to a certain type of transaction (for example, one that is centrally cleared1). On the other hand, the xVA components are orders of magnitude more complicated and require knowledge of contractual terms together with the economic impact of credit, funding, collateral and capital.
• Additivity. Whilst the ideal valuation is likely to be additive across transactions, xVAs are generally portfolio level calculations. Hence, whilst ideal valuations can be made at the transaction level, xVA terms must be calculated in a more portfolio-driven framework.
• Organisation. Whilst the idealistic, cashflow-driven valuation is suited to separate trading desks specialising in, for example, asset class, market, type of client or region, the xVA component necessitates management by a single desk. Such a desk is often known as the “xVA desk” or “central desk”.
Accounting and regulatory. The xVA world is very much driven by specific accounting and regulatory requirements that impact the way in which various terms are treated. Knowledge of these requirements is a critical aspect of xVA quantification.

1] At least from the central counterparty point of view

Read the rest of the article here.

Learn more about Jon Gregory and Global Derivatives 2017 here.

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