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Integrating Risk into Pre-Trade Analysis: Practical Ways of Bringing Credit, Liquidity, Funding and Regulatory Costs into an Integrated Profitability Framework

Company: Numerix LLC

Numerix LLC case study

Category: Credit Derivatives

Published: 26 November 2014

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Overview

As regulations in the derivatives market continue to be rolled out and implemented, financial institutions face growing pressure on their current business models. To survive and thrive in this new era of derivatives trading, today's practitioners need to adopt a more integrated and holistic approach for assessing trade profitability and allocating capital to their businesses.

The changing landscape of derivatives trading in recent years has led to shrinking margins, greater volumes and higher capital costs associated with derivatives trading. As a result, understanding and managing trade profitability with a complete understanding of the trade lifecycle is a critical need. Banks are competing more fiercely than ever for derivatives business, but now face a litany of other costs associated with trading derivatives. In addition to calculating the fair value, banks must account for what many practitioners are now calling, ‘the XVAs'(a term which includes CVA, DVA, FVA and other adjustments) to truly capture the costs of conducting derivatives business. A growing list of financial institutions, including some of the world's largest banks, have recently reported substantial FVA losses in their quarterly earnings. As a result, the question of profitability within derivatives trading is in the spotlight.

We will begin this article with an analysis of the post-crisis derivatives landscape. Next, we will discuss the concept of Trade EVA and look at a model that allows us to measure and attribute risk, funding and capital costs to each individual trade. We also touch upon other industry best practices for XVA implementation, such as handling data challenges in this new framework. Overall, our analysis highlights the need for greater operational

 

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