MVA: Forecasting initial margin for client trades and dynamic hedges

The panel

• Andrew McClelland, Director of quantitative research, Numerix
• Moderator: Philip Harding, Contributing editor, Risk.net

In its latest margin survey, the International Swaps and Derivatives Association reported that initial margin (IM) collected by the top 20 firms increased by 22% to $130.6 billion at the end of 2017. As new transactions become subject to IM requirements, and a wider range of buy-side firms fall into scope, the amount of regulatory IM being posted is expected to grow. 

From the perspective of trading economics, IM requirements are impactful, owing to the associated funding costs. This is the role of margin valuation adjustments (MVA), which represents the cost of funding IM requirements over the life of a trade or portfolio. 

Until now the focus of MVA has been primarily on the client trade. However, from a bank perspective, servicing clients can require posting IM for client trades and hedges. Thus, IM should be forecast for both and reflected in MVA. 

Using exotic swaptions as an example, Andrew McClelland, director of quantitative research at Numerix, identifies how IM requirements arise from client trades and the hedge trades they necessitate, and determine the total MVA impact of the trade to the bank. 

Among the key topics covered in this interview:

• The basic definitions and background of counterparty credit risk, variation margin, margin period of risk, IM and MVA
• Structure of an MVA calculation and forecasting sensitivities for IM
• IM for dynamic hedges – forecasting hedge ratios and hedge-side IM
• Example of a Bermudan hedged by vanilla swaps and swaptions
• When – and how much – hedge-side IM to charge on to clients

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