Journal of Credit Risk
ISSN:
1744-6619 (print)
1755-9723 (online)
Editor-in-chief: Linda Allen and Jens Hilscher
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Emulating the Standard Initial Margin Model: initial margin forecasting with a stochastic cross-currency basis
Need to know
- Modeling relevant risks is critical for xVA simulation frameworks, particularly when dealing with VaR based initial margin and margin valuation adjustment estimates.
- Often cross-currency bases are modeled deterministically which can compromise initial margin and margin valuation adjustment predictions for cross-currency instruments.
- Using a Hull-White-based xVA simulation model, we show that a minimal stochastic cross-currency basis extension can be effective in capturing cross-currency basis risk.
- The resulting initial margin profiles and margin valuation adjustments for cross-currency basis swaps can be brought in line with the International Swaps and Derivatives Association’s Standard Initial Margin Model.
Abstract
A common shortcut for forecasting initial margin requirements and margin valuation adjustments that are aligned with the International Swaps and Derivatives Association’s Standard Initial Margin Model relies on simulating and recalibrating value-at-risk quantiles. Doing so largely avoids costly sensitivity calculations but works only if the relevant risks are appropriately represented in the simulation model. In this paper we highlight the impact of missing cross-currency basis risk factors on estimating initial margin and margin valuation adjustments for instruments with a cross-currency basis sensitivity. We propose a parsimonious, consistent and efficient stochastic cross-currency basis model extension as remedy and provide illustrative examples. The examples cover vanilla interest rate swaps and resetting and non-resetting cross-currency basis swaps in Canadian dollars, euros, Japanese yen and US dollars. In addition to initial margin and margin valuation adjustment, we also compute and compare the impact on residual credit valuation adjustment.
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