Risk & Quant Consulting
Case Study – xVA
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The bank had given a variable loan to a major customer to fund an investment. The level of the interest rate of the long-term funding was hedged by accompanying interest rate derivatives between customer and bank. But when the investment was supposed to be activated, the economic realities had changed for the worse. This affected the economy of the investment operation. On top, the interest hedge developed negatively because the interest rate had dropped. From the perspective of the bank, an adverse situation developed due to increased claims—loan plus positive market value of derivatives—coinciding with a worsened collateralisation. The situation was made even more difficult as the interest and amortisation payments had to come from the investment although the revenue decreased.
The Strategy / Our Approach
The objective was to develop a solution that enables the client to reduce the interest payments and smooth them out over time—without touching the underlying loan. The adjustment was achieved purely synthetic using suitable derivatives. We generated innovative ideas and elaborated on those in the context of the operational requirements of the client and the loan parameters. Results were finalised in close co-operation of both parties. It was part of the challenge to harmonise the market- and risk-adjusted pricing from the perspective of the bank with the operative scope of the client. Special attention was given to the xVAs of the derivatives in the old and new business. Changes of the counterparty risks (solvency of client and investment, CVA), refinancing cost of the bank (FVA), and capital costs of the bank (KVA) contributed in detail to the pricing. Next to pricing, subsidiary agreements of the new overall agreement had to be aligned with the individual priorities of the involved parties.
For the development of alternative solutions and market- and risk-adjusted pricing of derivatives, we used our LPACalc-software. The high degree of flexibility of the software was ideal in this situation: regarding the relevant payment profile, auxiliary conditions, and state-of-the-art xVa-calculation.
For the benefit of the involved parties, we developed a solution to relax the financial situation and lay out a long-term coping strategy. From economic view point as well as in the balance sheet, we were able to realign interests regarding the product solution, and develop suitable pricing for the client’s situation. A side effect of the project was the high level of transparency: As a result, the trust between client and bank increased.