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New Book Offers Fresh Take on Mitigating Counterparty Risk

Counterparty Risk and Funding: A Tale of Two Puzzles

July 16, 2014, CHICAGO – A new book by Stéphane Crépey, Tomasz R. Bielecki and Damiano Brigo offers a fresh take on mitigation of counterparty risk, a key problem of the 2008 global credit crisis and current European sovereign debt crisis and consequently an increasing concern worldwide.

Counterparty Risk and Funding: A Tale of Two Puzzles (Chapman and Hall/CRC Financial Mathematics Series) gives a ground-up approach for analysis and managing of risks associated with non-payment of promised cash flows due to the default by a party in an over the counter derivative transaction.

It should be of value to researchers, graduate students, financial quants, managers in banks, CVA desks, and members of supervisory bodies.

Bielecki is a professor of applied mathematics at Illinois Institute of Technology (IIT) and the director of the university’s well-regarded Master’s in Mathematical Finance (MMF) program.

“Understanding the subtle interconnections between credit and funding is key to a modern valuation of derivatives,” said Fabio Mercurio, head of derivatives research, Bloomberg LP. “This timely contribution, written by world-class academics who are also well-recognized experts in the field, offers a rigorous and comprehensive treatment of the main theories underpinning the new valuation principles.”

Features:

  • Analyzes counterparty risk, funding, and the interaction between them
  • Shows how to solve the DVA/FVA overlap problem by switching from a full FVA to a funding LVA net of the bank’s own credit spread
  • Presents dynamic copula models of portfolio credit risk, including the Markov copula common-shock model
  • Gives a unified perspective on funding and counterparty risk models in terms of marked default times
  • Covers stochastic analysis prerequisites and the theory of Markov copulas in the mathematical appendix

The two “puzzles” alluded to in the title of the book are (rather than counterparty risk and funding in general):

  • The DVA/FVA puzzle regarding the interaction and possible overlap between DVA (own credit) and FVA (funding) terms;
  • The top-down versus bottom-up portfolio credit modeling puzzle, which the CDO industry had been trying to solve for a long time and has basically failed, that also needs to be addressed in order to properly deal with counterparty risk on credit derivatives.

Summary

Solve the DVA/FVA Overlap Issue and Effectively Manage Portfolio Credit Risk

Counterparty Risk and Funding: A Tale of Two Puzzles explains how to study risk embedded in financial transactions between the bank and its counterparty. The authors provide an analytical basis for the quantitative methodology of dynamic valuation, mitigation, and hedging of bilateral counterparty risk on over-the-counter (OTC) derivative contracts under funding constraints. They explore credit, debt, funding, liquidity, and rating valuation adjustment (CVA, DVA, FVA, LVA, and RVA) as well as replacement cost (RC), wrong-way risk, multiple funding curves, and collateral.

The first part of the book assesses today’s financial landscape, including the current multi-curve reality of financial markets. In mathematical but model-free terms, the second part describes all the basic elements of the pricing and hedging framework. Taking a more practical slant, the third part introduces a reduced-form modeling approach in which the risk of default of the two parties only shows up through their default intensities. The fourth part addresses counterparty risk on credit derivatives through dynamic copula models. In the fifth part, the authors present a credit migrations model that allows you to account for rating-dependent credit support annex (CSA) clauses. They also touch on nonlinear FVA computations in credit portfolio models. The final part covers classical tools from stochastic analysis and gives a brief introduction to the theory of Markov copulas.

The credit crisis and ongoing European sovereign debt crisis have shown the importance of the proper assessment and management of counterparty risk. This book focuses on the interaction and possible overlap between DVA and FVA terms. It also explores the particularly challenging issue of counterparty risk in portfolio credit modeling.

Mark Davis from Imperial College London said, “The landscape of the rates and credit markets has changed so drastically since the 2008 crisis that older textbooks are barely relevant and, from an analytic perspective, appropriate methods have to be rethought from scratch. The present volume is one of the best contributions in this direction, featuring a clear description of the various ‘value adjustments,’ new models for portfolio credit risk, a unified analytic framework based on BSDEs, and detailed treatment of numerical methods.”

Table of Contents:

See http://www.crcpress.com/product/isbn/9781466516458

About Illinois Institute of Technology

Founded in 1890, Illinois Institute of Technology is a Ph.D.-granting university located in Bronzeville on Chicago’s South Side. With more than 7,800 students in engineering, science, architecture, design, applied technology, human sciences, business and law, total enrollment in Fall 2013 was the highest since 1968 and the Fall 2013 full-time enrollment was the largest it has been since 1981. Visit www.iit.edu.