Kenyon: the right way to wrong-way risk and climate risk in XVA

Chris Kenyon, our Quantcast guest for this month, wears two pretty impressive hats. Not only does he head quantitative innovation for MUFG globally, he also heads its XVA modelling. Both require a good deal of creativity and out-of-the-box thinking.

And while these might seem obvious attributes for his role in the front office – where innovation is key – when it comes to the (dare we say less glamorous?) role of modelling counterparty risk and derivatives valuation adjustments, this skillset isn’t quite as obvious a requirement.

In his latest paper for Risk.net, Kenyon tackles the thorny issue of wrong-way risk (WWR) by seeking a solution well away from the beaten track.

WWR indicates the increasing exposure to a counterparty when its credit quality decreases. If it isn’t adequately addressed, a dealer could significantly miscalculate its credit valuation adjustment (CVA) and funding valuation adjustment (FVA).

Along with his co-authors – Mourad Berrahoui and Benjamin Poncet of Lloyds Bank – Kenyon notes how standard models for assessing WWR are fundamentally flawed.

“We looked at the literature to see what everybody else has done and we realised that the key problem is calibration,” Kenyon says during the podcast. They wondered what hedging instruments were available, and the perhaps surprising answer was, basically none. Which can lead to miscalculation of exposures.

Their approach to WWR calculation is data-driven. No model is used.

“We simply rewrite equations in a convenient form that can be estimated from historical data,” says Kenyon. To achieve this, the authors change the definition of WWR to reflect what data is in fact available for their estimate, circumventing the lack of long-dated instruments, such as CDS spread options with tenor longer than a year.

Finally, they note how, setting the problem this way, we can see that WWR and right-way risk can co-exist on a single point of the term structure, interfering with an objective valuation of risk.

The conversation then shifts to a stream of research Kenyon and Berrahoui started only last year: the impact of climate risk on derivatives pricing. The pair introduce climate risk valuation adjustment to complement CVA models. This includes the physical and transition risks from climate-related events – which extend to a much longer term than a 10-year credit default swap can capture.

Though the model is not easy to calibrate – and has to rely on some assumptions – the authors conclude the impact of this new term of default risk can be considerable.

This stream of research led them to develop a new concept – the carbon equivalence principle, by which the carbon flow enabled by a financial product should be attached to the product itself. Applying this principle, says Kenyon, “you can see what sort of footprint you are enabling”.

Applied to project finance, the results are striking, he says: certain types of asset could see their recovery rates change, which would change the funding spread, and with it the viability of the project – potentially forcing a redesign to make it investible.

But will the banking system adopt this kind of approach? They’ll no doubt need to put on their thinking caps.

Index

00:00 Intro and wrong-way risk

03:15 A data-driven approach

05:30 How large can WWR be compared with CVA?

06:30 Climate change valuation adjustment

10:08 The evolving literature of climate-related finance – the carbon equivalence principle.

14:00 Criticism of ‘ESG’ and ‘green’ labels

To hear the full interview, listen in the player above, or download. Future podcasts in our Quantcast series will be uploaded to Risk.net. You can also visit the main page here to access all tracks, or go to the iTunes store or Google Podcasts to listen and subscribe.

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