n Gregory
The xVA Challenge
This edition first published 2015
© 2015 John Wiley & Sons, Ltd
First edition published 2009, second edition published 2012 by John Wiley & Sons, Ltd
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ISBN 978-1-119-10941-9 (hbk) ISBN 978-1-119-10943-3 (ebk)
ISBN 978-1-119-10942-6 (ebk) ISBN 978-1-119-10944-0 (ebk)
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To Sylvia, Mimsie, Stella, Cara, Eliza-Joy, Stevie, Peach, Jim, Ginnie, George and Christy
Lists of Spreadsheets
One of the key features of the first and second editions of this book was the accompanying spreadsheets that were prepared to allow the reader to gain some simple insight into some of the quantitative aspects discussed. Many of these examples have been used for training courses and have therefore evolved to be quite intuitive and user-friendly.
The spreadsheets can be downloaded freely from Jon Gregory's website, www.cvacentral.com, under the counterparty risk section. New examples may be added over time.
Lists of Appendices
The following is a list of Appendices that contain additional mathematical detail. TheseAppendices can be downloaded freely from www.cvacentral.com.
Acknowledgements
The first edition of this book focused on counterparty credit risk and was written in 2009, during the aftermath of the global financial crisis. Since then, the subject matter has necessarily broadened to give more attention to aspects such as funding, collateral and capital. It has been less than three years since the second edition was finished and again, the subject has changed dramatically. Indeed, as before, this is much more than a new edition because most of the content has been rewritten and expanded with several new chapters. I hope this will be a comprehensive reference for the subject we now generally refer to as xVA.
As with the last edition, I have saved space by putting mathematical appendices together with the accompanying spreadsheets on my personal website at www.cvacentral. com. Since many do not study this material in depth, this has proved to be a reasonable compromise for most readers.
I have also made use of a number of survey results and I am grateful to Solum Financial and Deloitte for allowing me to reproduce these results. I am also grateful to IBM and Markit who have provided calculation examples. These will all be mentioned in the text.
Finally, I would like to thank the following people for feedback on this and earlier editions of the book: Manuel Ballester, Ronnie Barnes, Raymond Cheng, Vladimir Cheremisin, Michael Clayton, Daniel Dickler, Wei-Ming Feng, Julia Fernald, Piero Foscari, Teddy Fredaigues, Dimitrios Giannoulis, Arthur Guerin, Kale Kakhiani, Henry Kwon, David Mengle, Ivan Pomarico, Hans-Werner Pfaff, Erik van Raaij, Guilherme Sanches, Neil Schofield, Florent Serre, Masum Shaikh, Ana Sousa, Richard Stratford, Carlos Sterling, Hidetoshi Tanimura, Todd Tauzer, Nick Vause, Frederic Vrins and Valter Yoshida.
About the Author
Jon Gregory is an independent expert specialising in counterparty risk and related aspects. He has worked on many aspects of credit risk in his career, being previously with Barclays Capital, BNP Paribas and Citigroup. He is a senior advisor for Solum Financial Derivatives Advisory and is a faculty member for the Certificate of Quantitative Finance (CQR).
Jon has a PhD from Cambridge University.
1
Introduction
Get your facts first, then you can distort them as you please.
In 2007, a so-called credit crisis began. This crisis eventually became more severe and long-lasting than could have ever been anticipated. Along the way, there were major casualties such as the bankruptcy of the investment bank Lehman Brothers. Many banks were seen as being extremely reckless in the run-up to the crisis by taking excessive risks to provide gains for their employees and shareholders, and yet were inadequately capitalised for these risks. Governments around the world had to bail out other financial institutions such as American International Group (AIG) in the US and the Royal Bank of Scotland in the UK, and it became clear that it was essentially the taxpayer that was implicitly providing the capital against the risks being taken. AIG required more than $100 billion of taxpayers’ money to cover losses due to the excessive risk-taking. Many taxpayers have since faced poor economic conditions and have experienced the cost of these bailouts via higher taxes and reduced government spending.
One result of the “global financial crisis” (as the events from 2007 onwards shall generally be referred to in this book) was a clear realisation that banks needed to be subject to much stricter regulation and conservative requirements over aspects such as capital.