3: IRS – Crucial Other Considerations (CVA, FVA, …)

Mini Chapter Three

IRS - Crucial Other Considerations
(CVA, FVA, ...)

Other considerations while entering into a swap are counterparty credit risk and funding of cash flows (variation margin, CSA, CVA, FVA, wrong way risks to be discussed in detail in the risk section later).

What is counterparty credit risk for an interest rate swap?

Importantly on any swap, the 0 PV at the time of entering it is the result of PV of the expected average cash flows of the floating leg being offset by the PV of the expected average cash flows of the fixed leg, “average” being the key word. In other words for both a steep and or inverted yield curve there will be cash flow mismatches between floating and fixed legs on select reset periods (can very well be at the start of the swap too) even though the sum of the PV of all mismatches would be 0. These mismatches create counterparty credit risks (assuming no CSA/credit mitigation documents) and the risks change with movements in the underlying market.

• These credit risks are an inherent part of swaps pricing with hedging charges based on the counterparty credit risk profile and the volatility of the underlying product.

• Note that swap levels quoting in the market assume inter-bank/cleared risk (with credit mitigation) for the dealers, but while facing non-inter bank counterparties the credit risk hedging charges termed as CVA (credit value add) need to be reflected in the swap levels.

• Measurements of these charges are governed by a) movement in yields b) correlation between counterparty credit risk and the IRS movement (which if highly correlated is also known as “wrong way risk” c) Implied/expected Rates volatility to assess average and peak credit exposures. These risks are managed by CVA desks in banks.

• An intuitive way to think about CVA hedging – The CVA desk of a bank takes a fraction of the same risk that the bank dealer gets on the client flow (i.e. opposite of client risk). Which means a fraction of the mismatches as generated by the original risk is now in the CVA books. If the client loses money on the swap, the CVA desk’s position retains some gains for the bank which would have been lost otherwise if dealers had fully hedged the market risk. The CVA desk can also then use these gains to hedge the credit risk via buying protection on the counterparty’s obligations or via an instrument that reflects mitigation of the counterparty’s credit risk.

• CVA charge is mostly accommodated in the bid-offer of the swap. These credit risks can also be eliminated by simply exchanging the MTM of the swap on a daily basis as against an upfront CVA charge in the transaction. This gave rise to the concept of Collateralised Swap Agreements (CSA).

Funding of IRS cash flows

Now comes the funding of these mismatches. The rate of interest at which a counterparty funds these cash flows is the discount rate (which determines the discount curve) to calculate the PV of these cash flows. The traded swap curve however is the projection curve i.e. projects the expected floating benchmark across tenors. THE TWO CAN BE DIFFERENT. In case the CSA is in place the discount rate is the rate the two parties pay each other on the variation margin (CSA discounting), while in the absence of a CSA, discount rate is the rate at which the dealers fund their variation margin. For the latter, banks reflect them as FVA (funding value add) to be charged to the client that differs for different dealers depending on their respective funding curves.

As an example when you trade a USD LIBOR swap, the cash flows are projected using LIBOR, but they are discounted using the rate at which the two parties fund the cash flows i.e. USD OIS in most cases for inter-bank CSA participants. Hence while computing the PV of cash-flows, one would notice a LIBOR-OIS basis risk that would need to be hedged. Similarly for a local currency EM swap, say KRW NDIRS – the projection curve would project the 3m CD index while the cash flows would be discounted on USD OIS (assuming benchmark funding rate for dollar-based counterparties). Given that KRW PV would need to be funded against USD OIS the actual discount curve would be the KRW ND CCS vs USD OIS. As of today since ND CCS trades against USD SOFR, while computing the PV we would technically have some SOFR-OIS basis risk even though negligible as market uses these rates interchangeably.

• Trivia

Difference between 3m and 6m USD LIBOR came into prominence during the Global Financial Crisis when the 6m LIBOR curves started baking in a larger credit risk premium vs the 3 month benchmark. Previously cash flows on both 3m and 6m LIBOR swaps were discounted off their respective projection curves (as 6m could be interpolated exactly from the 3m curve) but once the curves started diverging dealers had to rebuild their models to discount them both off the USD funding curve.

This was 3m libor flat for most banks in the pre-CSA world and later changed to OIS once credit mitigation documentation was put in place.

Dual/Multi Currency CSAs

As part of CSA negotiations dealers also discussed the provision for margin posting in different currencies. For e.g. it was quite common in Japan to have CSAs that allowed either USD or JPY cash margins to be posted. More interesting is the fact that the funding rates on different currencies naturally follow their respective money markets and don’t really account for FX equivalent rates (cross currency basis discussed later). This gives rise to an optionality within the CSA whereby dealers can choose to switch between the currencies for margin posting (and effectively the discount curve for their trades) based on which one is cheaper to fund. This optionality is difficult to price due to the non-existence of observable trading prices for the correlation/ volatility between the two discount curves. But if dealers discover a way to hedge it, it could have an impact on pricing of swaps documented on dual currency CSAs.

Cleared and Uncleared/bilateral swaps

Since we haven’t yet discussed the details of a collateral swap agreement and related risk mitigation yet (to be covered later) for the sake of completion I’d just like to mention the concept of a cleared swap. A cleared swap places an exchange/clearing house in between the payer and the receiver to eliminate counterparty credit risk, by taking the onus of margining (initial and variation margins) from both parties. It also helps facilitate block unwinds at portfolio level for swaps traded with different counterparties but facing the same clearing house.

Exchange basis

Exchange basis (LCH-CME, LCH-JSCC etc.) – When net open positions or one sided positions of dealers become large on an exchange, the requirements to fund the Initial Margin increases making it more costly for dealers to trade more of the same direction on those swaps. In other words dealers are willing to pay a higher cost to get the other side of the swap facing that exchange/clearing house compared to what they are willing to pay for the same on other exchanges. This is what leads to a basis to develop for the same swap between two different exchanges. For example, asset managers that mostly dealt on CME and were fixed rate payers (assuming hedges on long bond positions) created sizable received open positions with dealers. These dealers were willing to pay higher for the same swap on CME compared to LCH (basis visible around mid-2015) as the higher cost was being offset by lower margin requirements for positions compressed on CME.

Use and hedging of Interest rate swaps

• Uses can be: a) unfunded expression of interest rate views on levered basis (recall leverage discussed earlier) b) enhancing portfolio returns i.e. overlays on long/short bond exposure c) hedging assets/liabilities and or converting fixed to floating or vice versa, sometimes by creating non-standard structures to match irregular cash flows.

• A received fixed position with a dealer can be hedged by a) paying the fixed rate (offsetting the swap) b) selling a futures contract on a similar underlying c) selling bonds/treasuries depending on its hedge value/minimise duration mismatches.