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OPTIMAL FUNDING STRATEGIES FOR COUNTERPARTY CREDIT RISK LIABILITIES
 

Summary: OPTIMAL FUNDING STRATEGIES FOR COUNTERPARTY CREDIT RISK
LIABILITIES
CLAUDIO ALBANESE, GIACOMO PIETRONERO, AND STEVE WHITE
Abstract. The Dodd-Frank Act [10] and the recently proposed Basel Committee regulatory
framework for CCPs [16] are a game changer for counterparty credit risk management. The
practice of charging an upfront fee as a Credit Valuation Adjustment (CVA) to provision against
counterparty credit risk liabilities is being abandoned as it was blamed for as much as two thirds
of the losses recorded during the financial crisis. Instead, a key role will be played by margin
financing, whereby periodically marked-to-market revolving lines of credit are used to cover
margin variations on a cross-product basis.
The emerging pay-as-you-go funding strategy for counterparty credit risk liabilities has a
fair value equal to the CVA upfront fee but an entirely different risk profile. Using margin
financing, the process for expected loss is locked at zero by construction and CVA volatility
risk is passed on to the counterparties themselves. As a side effect, wealth is transferred from
bankrupt entities to healthy ones. Moreover, in a Dodd-Frank world, there is no DVA because
there is no counterparty credit risk and the paradoxes of DVA accounting and CSA discounting
are removed.
To further optimize the funding strategy, interest inflows from portfolios of margin revolvers
can be redirected through securitization vehicles to a hierarchy of bond holders to which tranches
of risk are apportioned. With this construction, banks can purchase nearly full counterparty

  

Source: Albanese, Claudio - Department of Mathematics, King's College London

 

Collections: Mathematics