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Veronica Marchetti Muhammad Naeem

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1 Veronica Marchetti Muhammad Naeem
PRE-SETTLEMENT RISK Veronica Marchetti Muhammad Naeem

2 Agenda The Nature of Pre-Settlement Risk: Definition and Implications
An example of Pre-Settlement Risk Methods of estimation of Pre-Settlement risk Tools mitigating Pre-Settlement Risk Regulation Before and After the Crisis

During the last twenty years the sustained growth experienced by derivatives traded in Over The Counter markets has promped a need for an adequate measurement of the credit risk associated with such contracts. The detention of a financial instrument involving one or more cash flows to be paid at a later date in the future gives rise to a Pre-Settlement Risk, the risk that the counterparty may default before the contract’s final maturity.

THE NATURE OF PRE-SETTLEMENT RISK (2) COUNTERPARTY RISK PRE-SETTLEMENT RISK specialized category of credit risk that arises if or the financial intermediary responsible for the settlement declares bankruptcy before the transaction is settled. either the counterparty defaults before the payment is due Calculating potential credit loss require s the modeling of Three Processes The probability that default occur The counterparty credit exposure at time of default The amount that can be recoved after the default. EXPECTED LOSS= PD X EAD X LGD

5 Managing Credit Exposure
Exposure at default on OTC derivative transactions is determined by modeling the potential evolution of the replacement value of the portfolio of trades with each counterparty over the lifetime of all transactions. For all traded products, the exposure at default is derived from a Monte Carlo simulation of potential market moves in all relevant risk factors, such as interest rates and exchange rates The randomly simulated sets of risk factors are then used as inputs to product specific valuation models to generate valuation paths. In case of a default, it may be possible to recover part of the amount owed. The proportion of the amount which cannot be recovered is called loss given default. Probability of Default of the counterparty is computed through different techniques ; Linear Discriminant Analysis , Regression Models and Inductive Heurisitic Methods allow to discriminate the potential counterparties in relation to their creditworthiness.

Replacement cost is a basic metric of credit exposure due to pre-settlement risk.  It is the cost to the institution of having to completely replace all contracts with that counterparty. TYPE OF EXPOSURES ACTUAL EXPOSURE POTENTIAL EXPOSURE is the replacement cost of a portfolio of contracts with a counterparty based upon those contracts' current market values. The potential exposure of the contract is the maximum additional amount that will be lost if default occurs at some time t* , t< t*< T. DERIVATIVE POSITION LIABILITY ASSET NO CREDIT EXPOSURE CREDIT EXPOSURE In a third case the position can be an asset or a liability depending on the market fluctuation. So there is a possibility of loss when the position is an asset and no loss when the position is a liability

Operator A makes a forward purchase of foreign currency from operator B, let say the U.S. dollar to six months at the price of 1.1 euros per dollar. From the point of view of the operator A, the PRE-SETTLEMENT RISK refers to the possibility that, in the six months preceding the expiration date, the operator B becomes insolvent and simultaneously the position has a positive market value, i.e. the dollar is quoted at a higher price. Thus, for example, if three months later the dollar at three months is quoted at 1.2 euros, the operator A will suffer, in case of insolvency of B, a loss of 0.1 euros per dollar originally purchased. EURO VS DOLLAR 6 month =1.1 $ A $ $ B EURO VS DOLLAR 3 month B $ B =1.2 C A $ $ DEFAULTED

8 this is why the pre-settlement risk is also called substitution risk.
The pre-settlement risk produces a loss if, when the counterparty defaults, the market value of the contract is greater than zero. In this case the bank will have to face a cost when substituing the defaulted contract with a similar one at new conditions; this is why the pre-settlement risk is also called substitution risk. The worst case loss assumes an adverse movement in the price/ rate, the client default and the subsequent cost of re-covering the transaction again from the open market.

The main measures of pre-settlement risk are LOAN EQUIVALENT EXPOSURE and PEAK EXPOSURE . Pre Settlement Exposure (PSE) = MV of Derivative + Maximun Deviation of MV Estimating pre-settlement risk is a difficult task, in fact, the future substitution of a contract doesn’t only depend on its current value but also on the further value increase that may occur between now and the the time of counterparty’s default. FUTURE POTENTIAL EXPOSURE CURRENT EXPOSURE LEE Taken together, these exposures represent the LOAN EQUIVALENT EXPOSURE of an OTC derivative , that is, the value that can be assigned at the exposure in the event of a default.

10 Alternative Approaches
ESTIMATING PRE-SETTLEMENT RISK (2) The main ways to estimate the LEE associated with derivative contracts on interest rates and currencies were defined by the Basel Committee on Banking Supervision for regulatory purposes. LEE is computed using a parametric approach where percentiles can be expressed as multiples of the market factors’ historical volatility. LEE is computed using the ORIGINAL EXPOSURE METHOD, where CE and FPE are not assessed separately but LEE is computed directly as fixed percentage of the notional value of the contract. Alternative Approaches Alternative approaches to compute LEE based on option pricing models and historical / Montecarlo simulations. A VaR based approach is used in calculating the PSR limits when we want to set a limit to losses deriving from this kind of risk based on the worst case scenario.

PEAK EXPOSURE APPROACH Future Potential Exposue (FPE) changes with time and one has to choose the most appropriate time horizon or to find a way of summarizing different measures of EXPOSURE RISK into just one figure. This approach uses the maximum FPE relative to moment τ , i.e. the time in years when future value is estimated. Simple solution The Counterparty Risk is never underestimated BUT Overestimation of the effects of default AVERAGE EXPECTED EXPOSURE An alternative method is based on a weighted average of expected exposure for different τs using a system of weights proportional to the discount factors associated with different maturities.

12 VAR-based Approach Using volatility this model estimates the worst case possible price move (value at risk or VAR) and then estimates the value of the solution through pricing models. It then evaluates the impact of a default if the counterparty is unable to fulfill his commitment. WORST CASE MOVE VOL VAR DEFAULT IMPACT PRICING MODEL PSR Stress testing are used in particular after the crisis scenario of the last years and different stress test approaches are followed: Hypothetical & Historical stress testing, Expected Shortfall.

There are several ways to reduce pre-settlement risk; the main ones are the following: Recouponing and Guarantees Credit Triggers and Early Redemption Options Safety Margins Bilateral or Multilateral Netting Agreement

14 Recouponing and Guarantees
Bi-Multilateral netting agreements Netting Agreements allow to net all positions towards a defaulting counterparty, so that those with negative market value may offset the ones having a positive current exposure. If counterparties have multiple offsetting obligations to one another—for example, multiple Interest Rate Swap or FX Forward Contracts—they can agree to net those obligations. EXAMPLE OF THREE BILATERAL NETTING. If Party C defaulted, the replacement cost for Party A would be 3. For Party B, there would be no replacement cost because Party C owes it no net obligation. Party A 2 3 Party B Party C 1 Recouponing and Guarantees This tool is based on the fact that the periodic settlement of the market value of the OTC contract is replaced by a new one in line with current market conditions and in order to set the current exposure to zero.

15 Early Redemption Options
Credit Triggers and Early Redemption Options These are tools that allow for the early termination of the contract CREDIT TRIGGERS if a given event occurs , usually a rating downgrade for one of the two parties. REDEMPTION OPTIONS at the mere discretion of one counterparty Safety Margins Margins applied to OTC derivatives are similar to those required by central clearinghouses on futures: when two counterparties enter a futures contract, they have to provide an initial margin that will then be increased or decreased based on the daily changes in the market value of the contract.

“With a two-day dollar-yen deal, there’s not a lot of pre-settlement risk. But with a five-year dollar-Polish zloty swap? There’s risk there that someone might want to manage.” Derek Samman, head of FX at the CME Most market practitioners assess pre-settlement risk to be very low for spot transactions settled in two days For longer-dated trades, the risk is established by taking the appropriate spot rate and then assessing the interest differential between the two currencies to establish the forward . Such counterparty credit risk is currently managed in the FX market via either netting, covered within the close out netting clause in trading agreements or through the exchange of collateral between counterparties. The pre-settlement risk is minimized when counterparties are required to undergo a credit check before being approved for trading.

17 “Recommendations for Securities Settlement Systems”
REGULATION BEFORE THE CRISIS “Recommendations for Securities Settlement Systems” report of the CPSS-IOSCO Joint Task Force on Securities Settlement Systems, Bank for International Settlements, November 2001. Trade confirmation Confirmation of trades between direct market participants should occur as soon as possible after trade execution, but no later than trade date (T+0). Where confirmation of trades by indirect market participants (such as institutional investors) is required, it should occur as soon as possible after trade execution, preferably on T+0, but no later than T+1. Settlement cycles Rolling settlement should be adopted in all securities markets. Final settlement should occur no later than T+3. The benefits and costs of a settlement cycle shorter than T+3 should be evaluated.

18 “Recommendations for Securities Settlement Systems”
(2) Central Counterparties (CCPs) The benefits and costs of a CCP should be evaluated. Where such a mechanism is introduced, the CCP should rigorously control the risks it assumes. Securities lending Securities lending and borrowing (or repurchase agreements and other economically equivalent transactions) should be encouraged as a method for expediting the settlement of securities transactions. Barriers that inhibit the practice of lending securities for this purpose should be removed.

“Banks are of course looking again at all the risks they run and they’re definitely looking at pre-settlement risk and the potential need for longer-dated FX to be cleared, but I don’t think they see it as the biggest issue for FX.” Rob Close, chief executive of CLS. . Post-crisis reforms derive from the process of strenghten by the Congress and regulators of the establishment of central securities depositories and CCPs to immobilize paper certificates, encourage multilateral netting of trades, reduce pre-settlement risk through the guarantee of trades, and conduct securities settlements through "book entries" to electronic records. Today, the majority of FX derivative trades are executed and settled bilaterally, with market participants typically facing a bank throughout this process. A small minority of trades are executed on futures exchanges and centrally cleared. Under the proposed regulation, financial counterparties will be forced to centrally clear FX option products.

CREDIT DECISION TREE CLEARING BILATERAL CCPs CVA CSA Central clearing replaces the bilateral credit risk of the OTC market with systemically important CCPs as the legal counterparty to each trade. This clearing process will require the payment of initial and variation margin. In clearing bilaterally, there will be a choice between a collateralized approach using a Credit Support Annex (CSA), or an uncollateralized approach which is subject to a Credit Valuation Adjustment (CVA). Basel III regulations markedly increased the capital requirements and hence the cost of uncollateralized exposures in line with the tendency to strengthen clearing trade solution.

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