Derivatives pricing starts feeling the heat of climate change

Climate change is increasingly commanding attention from banks and regulators. Where it hasn’t yet been considered is in derivatives pricing – in particular, how both physical and transition risks will affect expected credit losses and funding costs of trades.

A recent paper, published on Risk.net, sets out to rectify that. It finds that the impact can be eye-watering, with credit valuation adjustment (CVA) potentially doubling as a result of climate-related events occurring in 20 to 40 years’ time.

Even risks crystallising much farther in the future raise the credit cost of shorter-maturity contracts. “The effect of a climate disruption taking 70 years to happen on a 20-year interest rate swap is a 23% increase in the CVA, assuming uniform approach to endpoint,” says Chris Kenyon, the paper’s co-author, referring to a uniformly increasing hazard rate.

While CVA rises, funding valuation adjustment (FVA) decreases, because a higher probability of counterparty default means less time paying funding costs. But the projected drops in FVA are small.

The research introduces climate change valuation adjustment (CCVA), which captures the difference between, on the one hand, CVA and FVA as they are typically calculated and, on the other hand, CVA and FVA that include economic stress from climate change.

To work out CCVA, Kenyon, who heads up quantitative innovation and valuation adjustment quant modelling at MUFG, and Mourad Berrahoui, head of counterparty credit risk modelling at Lloyds Banking Group, had to look beyond the spreads of credit default swaps (CDS) – the main input for calculating CVA and FVA.

“Most of the CDS trading is at the five-year point or 10 at most. Beyond 10 years, a lot of credit indices are simply not defined,” Kenyon says.

To extend the modelling beyond the 10-year horizon, Kenyon and Berrahoui turn to a type of so-called integrated assessment models – specifically those that take climate scenarios, and micro- and macroeconomic transmission channels and deliver economic impact scenarios. These models were devised by William Nordhaus, professor of economics at Yale University, and won him the Nobel Prize in 2018 “for integrating climate change into long-run macroeconomic analysis”.

So, the paper’s authors use current pricing models to compute CVA and FVA in the first 10 years of a trade’s existence and switch to a parametrisation of integrated assessment models after that point.

The overall model needs to be adjusted to account for the counterparty’s business sector, location and other characteristics as the impact from climate change will vary depending on these factors.

Survival rate

Kenyon and Berrahoui make two different assumptions on the hazard rate that describes the progress of climate change over time. In the first case, the hazard rate grows in a straight line from the end of traded CDS at 10 years to the climate change endpoint at 80 years, reaching the maximum level of 25%. In this case, the survival rate for a 30-year derivatives contract is estimated at 60%.

If, however, the hazard rate is assumed to grow faster in the run-up to the 80-year endpoint, still peaking at 25%, the survival rate comes out as an even worse 30%.

Not only are these numbers concerning, but the exercise highlights the high degree of uncertainty afflicting the financial modelling of climate change.

“In [these] examples we can see how changing the assumptions leads to widely diverging results,” says Fernando Mierzejewski, non-life risk officer at Belgian insurer Ageas. “I’d be cautious with the modelling of such long-term phenomena.”

But he still welcomes the overall framework proposed by Kenyon and Berrahoui as it provides a way to assess the impact of climate change on derivatives beyond the 10-year horizon.

The paper represents the first step towards integrating climate risk in derivatives pricing. The next step would be to consider how valuation adjustments related to capital and initial margin will change as the climate evolves. These may be affected even more than CVA and FVA, according to Stamatoula Matsoukis at Euclide Risk, who advises banks on valuation adjustments and credit counterparty risk.

“So far, I have not been asked by clients about climate change-related adjustments to [derivatives] pricing, though I expect that to happen in the near future,” she says.

Editing by Olesya Dmitracova