Quantifi newsletter Insight spring 2011

INSIGHTNEWSLETTER ISSUE 02 2011
Also in this issue:
Survey:
How do you Manage your
Counterparty Credit Risk?
Page 3
OIS and CSA Discounting
Page 6
of Counterparty Risk Management
Overcoming
the challenges
Waiting for CVA?

02 | www.quantifisolutions.com
The global financial markets are experiencing major changes
with new regulations and the impending Basel III capital
accord. While there is significant uncertainty about key
details of final regulations and implementation timelines,
there is a growing consensus and direction emerging for
a new OTC market landscape. Key drivers of this new
landscape include counterparty risk, a new valuation
framework adjusting for the cost of collateral agreements
called OIS discounting and central clearing.
Quantifi is focused on what is important to our clients and is
leading the market in developing solutions tailored for this new
OTC market landscape. In addition to a significant investment
in product development, as demonstrated by our QX.1 release
scheduled for this quarter, we have also published two recent
thought leadership pieces on the challenges of counterparty
risk implementation and derivatives valuation using OIS
discounting. The goal is to engage clients and the market
in the ongoing discussion around trends and best practices.
One important example of this engagement is our upcoming
seminar in London co-hosted with PRMIA where leading
industry practitioners and regulators will be joined by market
participants in a forum for discussion and sharing of ideas
around counterparty risk and CVA.
Through the first half of 2011 we have seen a continued pickup
in the OTC markets as evidenced by a host of new clients
including CM 10-CIC, Sterne Agee and CIMB. We see the entry
of new participants and an increase in risk appetite reflected
by a dramatic increase in the depth of the credit index options
market. We have also seen a rapid evolution and convergence
in the counterparty risk space towards that of the largest banks
and what we consider market best practice.
I look forward to an exciting second half of 2011 in what is
turning into a seminal year for the OTC markets.
ROHAN DOUGLAS, Founder and CEO
Message
from
the ceo
News
Client News:
CM10-CIC Selects Quantifi
One of the largest banking groups in
France sought a powerful and advanced
pricing and structuring tool. Compared
to the competitive solutions, Quantifi XL
proved to fit all necessary requirements.
“Quantifi has a strong track record in this
space and we expect to see significant
benefits as we now have access to a
proven solution that matches prices in
the market combined with responsive
support.” Senior Derivatives Trader
Linda Kessour, CM-CIC Marchés
CIMB Investment Bank Selects Quantifi
Malaysia’s largest investment bank
selected Quantifi XL, based on speed,
accuracy and flexibility, to support
its expanding operations. ”Securing
CIMB as a client is excellent news and a
welcome addition to our growing client
base both within the investment banking
sector and across Asia.”
Rohan Douglas, CEO, Quantifi
Sterne Agee Selects Quantifi
For the largest privately owned broker-
dealer in North America, Quantifi XL
has proved to be the ideal solution,
providing traders and salespeople with
immediate access to advanced pricing
and deal analysis at a fraction of the cost
of an internal build. Sterne Agee realises
an immediate competitive advantage
by rapidly scaling their business and
competing on a level playing field with
the most sophisticated global banks.
Product News:
CDS Index Option Models
Quantifi enhances its credit index option
models in response to client demand for
more sophisticated analysis and to support
for the latest market developments. “We
have been working closely with clients
to develop flexible tools for pricing
CDS index options, consistent with
techniques used in other markets. We
have implemented tools to calibrate credit
volatilities used in CVA pricing and hedging
from CDS index option quotes.” David
Kelly, Director of Credit Products, Quantifi

www.quantifisolutions.com | 03
Managing Counterparty Credit Risk
27% of firms actively manage and hedge CVA. 59% of
firms use exposure limits and 50% use counterparty
selection as their primary method for counterparty
credit risk management.
The trend is towards active management, as hedging
CVA is becoming increasingly important to offset
significantly higher regulatory capital requirements and
the impact of CVA volatility on earnings.
Timing of Major Changes
All respondents have or plan to implement major
changes in their counterparty risk systems. 41% of
respondents plan to complete major changes in
2012 or beyond.
As outlined in Quantifi’s recent whitepaper - ‘Challenges
in Implementing a Counterparty Risk Management
Process’ - the data, technological and operational
challenges can be significant and contribute to
extended implementation timelines.
Calculating CVA for New Trades
64% of respondents calculate CVA on new trades.
50% of these use an integrated calculator with
netting and collateral.
It is expected that the number of firms that calculate
marginal CVA on new trades, reflecting netting and
collateral, will continue to grow and evolve to near
real-time pricing.
Key Issues with Existing Counterparty Risk Systems
The largest challenge within existing counterparty
risk systems is data management and integration
(64%). The next largest challenge is the calculation
of CVA sensitivities.
Data management and integration is the most
widespread issue which reflects the diversity of
systems within most firms and the challenges around
integration and management of transaction, market
and reference data.
Another significant challenge is the calculation of CVA
sensitivities due to significant computational and
numerical complexities. Although many respondents
are not hedging CVA, the importance of CVA
sensitivities reflects the trend towards this goal.
Technology Initiatives
31% of firms are currently implementing of evaluating
vendor counterparty risk and CVA systems.
For many banks that have not yet implemented
counterparty risk management systems, a new
generation of vendor systems can provide a fast and
effective solution with reduced maintenance costs.
Key considerations for successful implementation
of a vendor solution include the number of systems
that must be integrated, data sourcing and format
conversions, and the ability to add proprietary models.
How do you manage your
counterparty credit risk?
Quantifi recently exhibited at the Global Derivatives and Risk Management conference in Paris and surveyed a cross
section of financial firms on the topic of counterparty credit risk. The purpose of the survey was to gain an insight into
the various approaches and timing in implementing counterparty risk management processes. This report highlights the
key preliminary findings1
.
• 27% of firms actively manage and hedge CVA.
59% of firms use exposure limits and 50% use
counterparty selection as their primary method
for counterparty credit risk management.
• All respondents have or plan to implement
major changes in their counterparty risk
systems. 41% of respondents plan to
complete major changes in 2012 or beyond.
• 64% of respondents calculate CVA on new
trades. 50% of these use an integrated
calculator with netting and collateral.
• The largest challenge within existing
counterparty risk systems is data management
and integration (64%). The next largest
challenge is the calculation of CVA sensitivities.
• 31% of firms are currently implementing
or evaluating vendor counterparty risk
and CVA systems.
Key Findings
Quantifi Survey
1
A number of respondents selected multiple answers

Most banks are in the process of setting up counterparty
risk management processes or improving existing
ones. Counterparty risk is increasingly being priced and
managed by a central CVA desk or risk control group
since the exposure tends to span multiple asset classes
and business lines. Moreover, aggregated counterparty
exposure may be significantly impacted by collateral and
cross-product netting agreements.
Gathering transaction and market data from potentially
many trading systems, along with legal agreements
and other reference data, involves significant and often
underestimated data management issues. The ability to
calculate credit value adjustments (CVA) and exposure
metrics on the entire portfolio, incorporating all relevant
risk factors, adds substantial analytical and technological
challenges. Furthermore, traders and salespeople expect
near real-time performance of incremental CVA pricing of
new transactions. Internal counterparty risk management
must also be integrated with regulatory processes.
In short, the data, technological, and operational
challenges involved in implementing a counterparty risk
management process can be overwhelming.
CVA & Capital: CVA is the amount banks charge their
counterparties to compensate for the expected loss from
default. Since both counterparties can default, the net
charge should theoretically be the bilateral CVA, which
includes a debt value adjustment (DVA) or gain from
the bank’s own default. While clearing and collateral are
the principal means for managing counterparty risk in
the inter-bank market, uncollateralised exposure is more
prevalent in the corporate derivatives market and banks
compete aggressively on CVA pricing. CVA pricing is
inherently complex for two reasons. First, the incremental
(or marginal) CVA for each trade should reflect the
application of collateral and netting agreements across all
transactions with that counterparty. Second, CVA pricing
models not only need to incorporate all of the risk factors
of the underlying instrument, but also the counterparty’s
‘option’ to default and the correlation between the default
probability and the exposure, i.e., right- or wrong-way risk.
Given the complexity, two problems arise. Some
banks are not able to compete for lucrative corporate
derivatives transactions because they do not take full
advantage of collateral and netting agreements with
their counterparties in calculating CVA. Or, they win
transactions because their models under-price some of
the risks and subject the bank to losses. The complexity is
compounded by the need for derivatives salespeople to
make an executable price in near real-time.
While CVA covers the expected loss from counterparty
defaults, economic or regulatory capital provides a
buffer against unexpected losses. Subject to approval,
the Internal Model Method (IMM) specified in the Basel
accord allows banks to use their own models to calculate
regulatory capital. The total regulatory capital charge for
COVER STORY
Waiting for CVA?
Overcoming
the challenges
of Counterparty Risk Management
by David Kelly, Director of Credit at Quantifi

counterparty risk is the sum of the counterparty default
risk charge and CVA risk capital charge. The counterparty
default risk charge is calculated using current market data,
either implied or calibrated from historical data. Three-
years of historical data are required, including a period of
stress to counterparty credit spreads. The CVA risk capital
charge was introduced in Basel III, as CVA losses were
greater than unexpected losses in many cases during the
recent crisis. The charge is the sum of the non-stressed
and stressed CVA VaR, based on changes in credit
spreads over a three-year period. Eligible credit hedges
can be included to reduce the total capital charge and
cleared transactions may be omitted.
Data & Technology: Gathering all the data necessary
to calculate CVA and capital reserves translates into
a very challenging technology agenda. Most banks
have multiple systems for reference data, market data,
and transactions. These systems may be further sub-
divided into front-office analytical tools and back-office
booking systems, each with its own repository of market
and reference data. The counterparty risk system must
integrate with potentially many of these systems in order
to extract the data needed to produce a comprehensive
set of counterparty risk metrics.
For a large bank, the counterparty risk system may price
something on the order of one million transactions over
one thousand scenarios and one hundred time steps, or
100 billion valuations. If the bank actively hedges CVA,
the number of valuations is roughly multiplied that by the
number of sensitivities required. The counterparty risk
system’s infrastructure must also support back-testing,
stress testing and historical VaR. In addition to fine-tuning
the analytics, acceptable levels of performance and
scalability can be achieved by distributing computations
across servers and processor cores using grid technology.
With the huge amount of data involved and analytical
complexity, the ability to view the various counterparty
risk metrics across a variety of dimensions is absolutely
essential. At the very least, the system should show
current and projected exposures, CVA and regulatory
capital by counterparty, industry and region. The ability
to inspect reference, market and transaction data inputs
is vital in verifying calculated results and tracking down
errors. The system must also provide reports for back-
testing, stress testing and VaR outputs with similar
aggregation and drill-down capabilities.
Trends: Post crisis, the ability for senior management
to get a comprehensive view of the bank’s counterparty
risks is a critical priority. Consolidated risk reporting
has been elusive due to front-office driven business
models. As influential revenue producers, trading desks
have maintained a tight grip on data ownership, model
development and front-office technology. This has
resulted in a proliferation of systems, making the job
of aggregating risks across business lines excessively
complicated. Continuous development of new types
of derivative payoffs and structured products has
exacerbated the problem. But the failures and near
failures of several global banks have changed the
traditional mentality. Banks are now taking a ‘top-down’
approach to risk management. Decision-making authority
is transitioning from the front-office to central market and
credit risk management groups.
A key component of the top-down approach to risk
management is the central CVA desk or counterparty risk
group. In practice, the CVA desk sells credit protection
to the originating trading desk, insuring them against
losses in the event of a counterparty default. Housing
counterparty risk in one place allows senior management
to get a consolidated picture of the exposures and
proactively address risk concentrations and other issues.
As banks continue to ramp up active management
of CVA, having a specialised group allows careful
management of complex risks arising from liquidity,
correlation and analytical limitations.
Decentralised infrastructures may make the data and
technology challenges too great to ensure provision of
meaningful consolidated counterparty risk metrics on
a timely basis. Some banks have aligned counterparty
risk management by business line in order to more
effectively manage the data and analytical issues at the
expense of certain benefits, like netting. For centralised
CVA desks, there is also the challenge of internal pricing
and P&L policies. Most banks position CVA desks as
utility functions that simply attempt to recover hedging
costs in CVA pricing.
Recent regulatory activity has also had a profound impact
on counterparty risk management. Mandating central
clearing for an expanding scope of derivative products
effectively moves counterparty risk out of complex CVA
and economic capital models and into more deterministic
and transparent margining formulas. The heavily
collateralised inter-dealer market is also undergoing
significant changes. Institutions are now looking more
closely at optimising collateral funding through cheapest-
to-deliver collateral, re-couponing existing trades to
release collateral, and moving positions to central
counterparties in order to access valuation discrepancies
or more favorable collateral terms.
It is expected that most corporate derivatives transactions
will remain exempt from clearing mandates since
banks provide valuable hedging services in the form
of derivative lines. The cost of extending these lines is
increasing due to significantly higher regulatory capital
requirements. Therefore, competitive CVA pricing and
economic capital optimisation will remain priorities for
corporate counterparty risk management alongside
collateral and clearing processes.

Following the credit crisis, interest rate
modelling has undergone nothing short
of a revolution. During the credit crisis,
credit and liquidity issues drove apart
previously closely related rates. For
example, Euribor basis swap spreads
dramatically increased and the spreads
between Euribor and Eonia OIS swaps
diverged. In addition, the effect of
counterparty credit on valuation and risk
management dramatically increased.
Existing modelling and infrastructure no
longer worked and a rethink from first
principles has taken place.
Today a new interest rate modelling framework is
evolving based on OIS discounting and integrated credit
valuation adjustment (CVA). Pricing a single currency
interest rate swap now takes into account the difference
between projected rates such as Euribor that include
credit risk and the rates appropriate for discounting cash
flows that are risk free or based on funding cost. This
approach is referred to as dual curve, OIS discounting,
or CSA discounting and forces a re-derivation of
derivatives valuation from first principles. In addition,
the counterparty credit risk of (uncollateralised) OTC
transactions is measured as a CVA.
Impact of the Credit Crisis on
the Rates Market
As the credit crisis unfolded, there were significant
impacts on the structure and dynamics of the rates
market. Credit and liquidity drove segmentation and
rates that were previously closely related diverged,
causing a rethink of how these rates should be modelled.
Reflecting the different credit risk and market
segmentation between different Euribor rate tenors,
basis swap spreads blew out during the crisis from being
fractions of a basis point (where they had been quoted
for decades) to double digits in a matter of months. The
3M Vs 6M Euribor Basis swap spread went from under a
basis point to peak at over 44bp around October 2008,
after the Lehman default. This divergence is again a
FEATURE
by rohan douglas, CEO of Quantifi
and Peter Decrem, Director of Rates at Quantifi

reflection of different credit and liquidity risks between
these indices. The longer term deposits (6M) carry more
credit risk than the shorter (3M) deposits.
The New Interest Rate
Modelling Paradigm
Clearly the credit crisis had a significant impact
on the interest rates market. These changes have
driven a profound shift in the way all OTC products
are valued and risk managed. The result has been
an abandonment of the classic derivatives pricing
framework based on single interest rate curves and
the introduction of a new approach that takes into
account current interest rate dynamics and market
segmentation using multiple curves.
Dual Curve/OIS Discounting:
The old-style no-arbitrage, single-curve derivatives
valuation framework where Euribor was a reasonable
proxy for a risk-neutral discount rate has been
permanently changed by the credit crisis. An
understanding of the credit risk embedded in Euribor
and similar rates and an increased importance in
the modelling of funding have driven a separation
between the index rates used for the floating legs of
the swap (the projection rates) and the appropriate
rates used for present value (the discount rates). The
market-standard rate to discount future cash flows is
now OIS rates.
The method of projecting rates using Euribor
and discounting rates using Eonia changes the
fundamental framework for existing derivative
modelling. It has required a rethink from first principles
that continues to be discussed and refined. Pricing
and risk managing even a vanilla single currency
swap has become significantly more complex. Curve
construction, pricing and hedging now involve
multiple instruments and additional basis risks. These
complexities compound for interest rate products such
as cross currency swaps, caps/floors and swaptions.
Counterparty Risk and CVA:
The measurement and management of counterparty
risk is now something that impacts all market
participants. Accurate valuation of OTC products now
requires accurate valuation of the credit component
of each transaction. In addition, regulatory initiatives
such as Basel III and Solvency II, along with accounting
rules such as ASC 820 (FAS 157) and IAS 39 have
mandated more accurate counterparty risk valuation
and risk management.
The larger banks have led the evolution of valuing
and managing counterparty credit risk. Over time they
have converged to generally consistent methods and
processes. The concept of a CVA is now widely accepted
and consistently calculated across the markets. OTC
transactions that carry counterparty exposure executed by
all the larger institutions now have a CVA component as
part of the valuation.
Dual Curve OIS Discounting
Curve Construction
Following the credit crisis, interest rate derivatives
are now valued with models that reflect the observed
market segmentation, counterparty risk, and interest
rate dynamics. Valuing a single currency vanilla interest
rate swap involves calculating forward rates based
on Euribor rate curves and discounting expected
cash flows using Eonia rates. As in the single-curve
case, these curves are calibrated from liquid interest
rate products. For the EUR curves this includes
money market securities, futures, FRAs, Eonia swaps,
basis swaps and interest rate swaps. The process is
complicated, however, by changes to the modelling
principles around calculating the expected forward
rates. These forward rates must be conditional on the
Eonia rates used for discounting.
A new generation of interest rate modelling is
evolving. An approach based on dual curve pricing
and integrated CVA has become the market
consensus. There is compelling evidence that the
market for interest rate products has moved to pricing
on this basis, but not all market participants are at
the stage were existing legacy valuation and risk
management systems are up to date. The changes
required for existing systems are significant and
present many challenges in an environment where
efficient use of capital at the business line level is
becoming increasingly important.
“A new generation of
interest rate modelling is
evolving. An approach based
on dual curve pricing and
integrated CVA has become
the market consensus.”

© Quantifi Inc. All rights reserved. Quantifi, Quantifi Risk, Quantifi XL, Quantifi Counterparty Risk, Quantifi CVA are trademarks of Quantifi Inc.
ABOUT QUANTIFI
Quantifi is a leading provider of analytics, trading and risk management software for the Global Capital Markets. Our suite
of integrated pre and post-trade solutions allow market participants to better value, trade and risk manage their exposures
and respond more effectively to changing market conditions.
Founded in 2002, Quantifi is trusted by the world’s most sophisticated financial institutions including five of the six largest
global banks, two of the three largest asset managers, leading hedge funds, insurance companies, pension funds and other
financial institutions across 15 countries.
Renowned for our client focus, depth of experience and commitment to innovation, Quantifi is consistently first-to-market
with intuitive, award-winning solutions.
enquire@quantifisolutions.com | www.quantifisolutions.com
Europe: +44 (0) 20 7397 8788 • North America: +1 (212) 784 6815 • Asia Pacific: +61 (02) 9221 0133
Whitepapers
• A new generation
of interest rate
modelling based on
dual curve pricing and
integrated CVA
is evolving
Challenges in
Implementing
a Counterparty Risk
Management
Process
• Key data and technology challenges
• Current trends in best practices
Evolution of
Counterparty Credit Risk
• Explores practical implementation issues and
how approaches have converged
• An insider’s view from the major banks that
have influenced this market
Request a copy:
enquire@quantifisolutions.com
QX.1 Preview
QX.1 is Quantifi’s next major release on
schedule for this quarter. QX.1 will include
significant enhancements across all of Quantifi’s
product range and continues our tradition of
first to market releases that address our clients’
needs. A sample of new features include:
• Expanded asset coverage and product
enhancements for FX options and
exotics, basis swaps, callable bonds,
convertible bonds, FRAs, swaptions
and credit index options
• Significant enhancements to counterparty
risk management including Basel III compliant
capital calculations, historical CVA VaR, stress
testing, back-testing, enhancements to
margin period of risk calculations, collateral
thresholds by rating, additional calibration
tools and extended product coverage for
commodities and inflation
• Expanded data management capabilities
to simplify complex data integration and
data management
• A new generation of APIs for plug-and-
play client model integration, product
extendibility, and data integration
• A redesigned reporting engine with in-
memory hypercube for improved reporting
and drill down flexibility, simplified integration
of external data sources, and improved
performance for high-volume portfolios
www.quantifisolutions.com
Co-Authored by Rohan Douglas and Peter Decrem (Quantifi)
• A new generation of interest rate modelling based on
dual curve pricing and integrated CVA is evolving
• This new framework requires a rethink of derivative
modelling from first principles and presents significant
challenges for existing valuation, risk management, and
margining systems
WHITE PAPER
OIS AND CSA DISCOUNTING
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Quantifi newsletter Insight spring 2011

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