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PROFESSOR: Our last class Yi is running from his home

in New Jersey due to snow.

So he couldn't fly in.

But actually, now I'm learning a lot.

It's a good way to run the classes going forward.

I think.

We may employ it next year.

So Yi will present CV modeling for about an hour.

And then Jake, Peter and myself, we will do concluding remarks.

We will be happy to answer any questions on the projects

or any questions whatsoever.

All Right?

So Yi, please.

Thank you.

YI TANG: OK.

I'm here.

Hi everyone.

Sorry I couldn't make it in person because of the snow.

And I'm happy to have this opportunity

to discuss with you guys counterparty credit

risks as a part of our enterprise-level derivatives

modeling.

I run a Cross Asset Modeling Group at Morgan Stanley.

And hopefully you will see why it's

called Cross Asset Modeling.

OK, counterparty credit risk exists mainly

in OTC derivatives.

We have an OTC derivative trade.

Sometimes you owe your counterparty money.

Sometimes your counterparty owes you money.

If your counterparty owes you money, on the payment date,

your counterparty may actually default,

and therefore, either will not pay you

the full amount it owes you.

The default event includes bankruptcy, failure to pay

and a few other events.

So obviously, we have a default risk.

If our counterparty defaults, we would

lose part of our receivable.

However, the question is before the counterparty defaults,

do have any other risks?

Imagine you have a case where your counterparty will pay you

in 10 years.

So he doesn't need to pay you anything.

Then the question is are you concerned

about counterparty risks or not?

Well, the question is yes, as many of you probably know,

it's the mark-to-market risk due to the likelihood

of a counterparty future default.

It is like the counterparty spike widens,

even though you do not need a payment from you counterparty.

If you were to sell, a derivative trade

to someone, then someone may actually worry about that.

So therefore the mark-to-market will

become lower if the counterparty is spread wider.

This is similar to a corporate bond in terms of economics.

You own a bond on the coupon payments date,

or on the principal date, the counterparty can default.

Of course, they can default in between also.

But in terms of terminology, this

is not called counterparty risk.

This is called issue risk.

So here comes the important concept credit valuation

adjustment.

As we know the counterparty is a risk.

Whenever there's a risk, we could put a price on that risk.

Credit valuation adjustment, CVA,

essentially is the price of a counterparty credit risk.

Mainly mark-to-market risks, of course,

include default risk too.

It is an adjustment to the price of mark-to-market

from a counterparty-default-free model, the broker quote.

So people know, there's a broker quote.

The broker doesn't know the counterparty risk.

A lot of our trade models do not know the counterparty risk

either, mainly because of we're holding it back,

which I will talk about in a minute.

Therefore, there is a need to actually

have a separate price of CVA to be

added to the price for mark-to-market

from counterparty default free model

to get a true economic price.

In contrast, in terms of a bond, typically there's

no need for CVA because it is priced in the market already.

And CVA not only has important mark-to-market implications,

it is also a part of our Basel III capital.

Not only change your valuation, but could impact your return

on capital.

Because of a CVA risk, the capital requirements

typically is higher.

So you may have a bigger denominator in this return RE,

return on capital or return on equity.

CVA risk, as you may know, has been a very important risk,

especially since the crisis in 2008.

During the crisis, a significant financial loss actually

is coming from CVA loss, meaning mark-to-market loss

due to counterparties' future default.

And this loss turned out to be actually

higher than the actual default loss

than the actual counterparty default.

Again, coming back to our question,

how do we think in terms of pricing a derivatives

and price the CVA together with the derivatives.

First of all, it adds some portfolio effect

the counterparty can trade multiple trades.

And the default loss or default risk

can be different depending on the portfolio.

And when people use a trade-level derivatives model,

which is by default what people would call a derivatives model,

typically you price each trade, price one trade at time.

And then you aggregate the mark-to-market together

to get a portfolio valuation.

So when you price one trade, you do not

need to know there may be another trade facing

the same counterparty.

But for CVA or counterparty risk, this is not true.

We'll go over some examples soon.

This is the one application of what

I call enterprise-level derivatives,

essentially focusing on modeling the non-linear effects,

non-linear risks in a derivatives portfolio.

Here's a couple of examples.

Hopefully, it will help you guys to gain some intuition

on the counterparty risks and CVA.

Suppose you have an OTC derivatives trade, for instance

like an IR swap.

It could be a portfolio of trades.

Let's make it simple.

Let's assume the trade PV was 0 on day one.

Of course, we assume we don't know anything

about the counterparty credit risk.

We don't know anything about CVA.

This is just to show how CVA is recognized by people.

So to start with again, the trade PV

was 0 on day one, which is true for a lot of co-op trades.

And then the trade PV became $100 million dollars later on.

And then your counterparty defaults with 50% recovery.

And you'll get paid $50 million of cash.

OK, so $100 million times 50% recovery.

If the counterparty doesn't default,

you eventually would get $100 million.

Now he defaults, you get half of it, $50 million.

The question is have you made $50 million dollars

or have you lost $50 million over the life of the trade.

Anyone have any ideas?

Can people raise your hand if you think

you have made $50 million?

Can I see the people in the class?

I couldn't see anyone.

PROFESSOR: How do I raise this?

YI TANG: OK, no one thinks you made the $50 million.

So I guess then, did you all think

you have lost $50 million?

Can people raise their hand if you think

you have lost $50 million?

OK, I see people.

Some people did not raise your hand.

That means you are thinking you are flat?

Or maybe you want to save your opinion later?

OK, so this is a common question I normally

ask in my presentation.

And I typically get two answers.

Some people think they've made $50 million.

Some people think they've lost $50 million.

And there was one case, someone said OK, you know they're flat.

Now, this would look like a new interesting situation

where no one thinks you made $50 million.

I mean, come on, you have $50 million of cash in the door.