Regulatory-Optimal Funding

Funding is a cost to trading desks that they see as an input. Current FVA-related literature reflects this by also taking funding costs as an input, usually constant, and always risk-neutral. However, this funding curve is the output from a Treasury point of view. Treasury must consider Regulatory-required liquidity buffers, and both risk-neutral (Q) and physical measures (P). We describe the Treasury funding problem and optimize against both measures, using the Regulatory requirement as a constraint. We develop theoretically optimal strategies for Q and P, then demonstrate a combined approach in four markets (USD, JPY, EUR, GBP). Since we deal with physical measures we develop appropriate statistical tests, and demonstrate highly significant (p<0.00001), out-of-sample, improvements on hedged funding with a combined approach achieving 44% to 71% of a perfect information criterion. Thus regulatory liquidity requirements change both the funding problem and funding costs.Comment: 20 pages; 8 figures; 2 tables, Risk, April 201

CDS pricing under Basel III: capital relief and default protection

Basel III introduces new capital charges for CVA. These charges, and the Basel 2.5 default capital charge can be mitigated by CDS. Therefore, to price in the capital relief that CDS contracts provide, we introduce a CDS pricing model with three legs: premium; default protection; and capital relief. If markets are complete, with no CDS bond basis, then CDSs can be replicated by taking short positions in risky floating bonds issued by the reference entity and a riskless bank account. If these conditions do not hold, then it is theoretically possible that the capital relief that CDSs provide may be priced in. Thus our model provides bounds on the CDS-implied hazard rates when markets are incomplete. Under simple assumptions we show that 20% to over 50% of observed CDS spread could be due to priced in capital relief. Given that this is different for IMM and non-IMM banks will we see differential pricing?Comment: 16 pages, 10 figues, 3 table

Collateral-Enhanced Default Risk

Changes in collateralization have been implicated in significant default (or near-default) events during the financial crisis, most notably with AIG. We have developed a framework for quantifying this effect based on moving between Merton-type and Black-Cox-type structural default models. Our framework leads to a single equation that emcompasses the range of possibilities, including collateralization remargining frequency (i.e. discrete observations). We show that increases in collateralization, by exposing entities to daily mark-to-market volatility, enhance default probability. This quantifies the well-known problem with collateral triggers. Furthermore our model can be used to quantify the degree to which central counterparties, whilst removing credit risk transmission, systematically increase default risk.Comment: 12 pages; 5 figure