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Numerix Introduces a New Algorithmic Method for Calculating Counterparty Exposure and its Application to Complex Risk Measures

Published on 18 Jul 2012

 Numerix announced the results of its latest quantitative research “Algorithmic Exposure and CVA for Exotic Derivatives” contributed to by Alexander Antonov, SVP of Quantitative Research, Serguei Issakov, SVP Quantitative Research & Development and Serguei Mechkov, SVP of Quantitative Research. 

The paper establishes a new algorithmic method for calculating Counterparty exposure for exotic portfolios and automates its application to computing Monte Carlo simulated measures for Market Risk and Counterparty Risk, including Monte Carlo VaR (Value at Risk), Expected Shortfall, PFE (Potential Future Exposure) and CVA (Credit Value Adjustment). Recognized as a more advanced measure of Counterparty Risk, and required by Basel III, CVA is an adjustment to the price of any financial instrument due to the possible default of a Counterparty.

“This paper introduces a theoretical framework that can be used to reconcile various approaches to computing risk with the same level of speed and accuracy as pricing, helping to create a common language for the front and middle offices,” said Serguei Issakov, SVP Quantitative Research & Development. “While there is a consensus on how to compute price, there are various approaches to achieve risk computations – which don’t always agree with each other. We found that by calculating exposure in parallel with pricing a unified, more efficient approach can be taken to computing complex risk measures.”

Fundamental to this approach is the concept of exposure-centric analytics, which generalizes the existing price-centric analytics, as a rigorous framework for computing Market Risk and Counterparty Risk. As such, this method also naturally lends itself to computing Economic Scenario Generators by applying economic variables to the scenario generation framework.

“I’m proud of the groundbreaking research our dedicated R&D team has brought to market, helping to advance model transparency and increase understanding of today’s complex derivatives market,” said Steven R. O’Hanlon, President and Chief Operating Officer at Numerix. “Under Basel III CVA changes the most fundamental assumptions in OTC derivatives pricing requiring a portfolio and counterparty level view of trades. It can be costly and challenging so we’re honored to present this timely, impactful work.”

 

Below is the abstract of the detailed version of the paper:

We develop the algorithmic approach for Counterparty exposure calculation and automate its application to arbitrary complicated instruments. Assuming that the portfolio is priced by the backward (American) Monte-Carlo method, our approach allows calculating the credit exposure as a pricing by-product, essentially without modifications in the usual pricing procedure. In particular, for the exposure calculation of callable instruments we manage to avoid a cumbersome aggregation of exercise indicators, applying them sequentially in parallel with the main pricing.

We explain how the obtained exposure can be integrated into the Credit Valuation Adjustment (CVA), based on the extension of the pricing model with a Counterparty credit component. The presented approach to the exposure computation is formulated in an arbitrary probability measure. To perform the measure change we use the cross-currency model semantics and calibrate the model to the real-world measure using indexes projections.

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Product type:	Algorithmic Trading | Derivatives | Risk Management

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