According to a new paper by Alexander Sokol, Chief Executive Officer of technology vendor CompatibL, Leif Andersen, Global Co-head of the quantitative strategies group at Bank of America Merrill Lynch, and Michael Pykhtin, a manager in the quantitative risk team at the Federal Reserve Board in Washington, DC, and quoted by Risk.net, calculations of credit risk in an over-the-counter derivates trade executed with conventional means can underestimate the real exposure by up to half. The paper will be published in the Journal of Credit Risk in 2017.
In addition, the researchers pointed out that initial margin effectiveness for derivatives trades is also questionable: the exposure is in fact reduced by a factor of 10, rather than the expected factor of 120.
Alexander Sokol, Leif Andersen, and Michael Pykhtin found that calculation errors are caused by making simplifying assumptions on how the default works.
As the accuracy of credit valuation adjustment (CVA) calculations is significantly impacted by exposure spikes, realistic assumptions are essential to capture the impact of trade payments. These spikes, if undetected, may dominate the true exposure. “It may become the dominant contribution to credit valuation adjustment and significantly reduce the effectiveness of the initial margin in reducing counterparty credit risk,” says Sokol, on Risk.net.
The solution is simple, the authors concluded: The International Swaps and Derivatives Association should change the Credit Support Annex to reduce the exposure.
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