A guiding light for corporates lost in the fog of XVAs

Chris Kenyon proposes a framework for optimising XVAs – from the client perspective

There’s an old joke about a lost tourist asking a local for directions and being told: “Well, if I wanted to go there, I wouldn’t start from here.” That sums up the predicament of corporates looking to trade uncollateralised swaps in times of market stress, when credit spreads and funding costs can be painfully high.

Dealers must consider their funding costs (FVA) and the credit valuation adjustment (CVA) of the client when pricing the trade. These are locked-in at the beginning and held for the life of the trade, which could easily be up to 20 years.

Corporates can employ contractual strategies such as mandatory breaks, restructurings and resets to mitigate some of these XVA charges. These are included in standard term sheets for derivatives and are available to both counterparties to a trade. But while banks have developed methodologies to optimise XVAs, most clients lack a rigorous quantitative methodology for selecting the right terms for a given situation. As a result, they often choose the wrong path.

For instance, corporates increasingly use mandatory breaks to lower XVA charges. “From what I can see in the market, mandatory breaks are becoming more common, while resets are still used less,” says a senior XVA quant at a major European bank.

New research from Chris Kenyon, head of XVA quant modelling at MUFG Securities in London, suggests this might not always be the right choice.

While they appear similar in many ways, mandatory breaks and resets are different in one important regard. The former is a legal agreement to end a derivatives contract – often with a view to entering a new trade, called a continuation contract, after exiting the old one. With a reset, the original contract remains in place but its terms are rearranged in such a way that the present value is zero.

This has significant implications for XVA pricing. When signing a derivative with a mandatory break, the bank cannot be sure the client will enter a continuation trade after the break. Therefore, it will consider the credit exposure up to the break only. The continuation will be priced separately, based on the prevailing credit conditions. With a reset, the bank will look at its credit exposure over the entire duration of the contract, including the reset period.

“Resets are actually better than mandatory breaks if there is a good credit level, because with them you lock in a good credit level now for CVA over the life of the trade,” says Kenyon. “Whereas if you have a mandatory break, you’ve got the risk of your credit level increasing. Restructuring is somewhat different from both in relying on rebates, and mixes features of both.”

From what I can see in the market, mandatory breaks are becoming more common, while resets are still used less
Senior XVA quant at a European bank

Kenyon’s research offers a roadmap for clients. His paper examines the conditions under which a reset may be preferred to a mandatory break, or vice versa. Crucially, given the optimal strategy will depend on the credit quality of the corporate and near-term expectations for its business, Kenyon also looks at the scale of credit moves in past crises and how long it typically takes for CDS levels to recover from a shock.   

“This paper is the first I’m aware of that looks at XVA from the client’s point of view,” says the senior XVA quant. “I don’t think there are enough papers out there that try to solve problems for clients, so it’s definitely valuable for them to take these results into account before taking decisions on their XVA management.”

Kenyon’s research will prove useful for many derivatives users, but some caution against putting his theory – however rigorous – into day-to-day practice. Jon Gregory, an XVA consultant, says including mandatory breaks or resets in derivatives terms may have a negative effect on a corporate’s creditworthiness or liquidity management. “It is very interesting that clients are provided with a quantitative formula for this problem, but there may be qualitative reasons why they disagree with the conclusion,” he says.

That’s a valid point. But having a theoretical framework can only help corporates make wiser decisions.

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