A time for special FX

Dealers are beginning to think a lot more seriously about credit-adjusting the prices they quote on foreign exchange derivatives. How are they calculating this, and how are clients responding to the move? By John Ferry

Supermarkets are often harangued for pricing alcohol so low they actually make a loss on it. The idea is that customers decide to use a particular store to buy their alcohol, but conclude they may as well do the rest of their shopping while they are there - and it is on the other products thrown into the trolley that the company makes its profit. Big supermarkets, however, are not the only entities that price some products cheaply and look elsewhere for their profits. In the face of near perfectly competitive markets, big banks have also traditionally been forced to deploy this tactic in foreign exchange.

The market for vanilla forex products such as forwards is so competitive that, when all the costs of a deal are fully accounted for, including the price of the counterparty credit risk exposure the bank takes, dealing desks have made next to nothing on many of their transactions in the past. Instead, as with the supermarkets, the banks have relied on other business for their profits - in other words, get the client in the door through ultra-competitive pricing on forwards, then hope to sell them other higher-margin products once a relationship is established.

The credit crisis, and in particular the collapse of Lehman Brothers on September 15, has changed all that. Now, dealers are acutely aware they need to price counterparty credit risk into any quote, even for those corporate counterparties perceived to be rock solid, or be left with a potentially nasty loss if that entity goes bust. Some of the larger, most sophisticated dealers have been doing this, to some degree, for some time - although competitive pressures have curtailed how far many are willing to go. However, industry professionals are now looking to refine calculations to ensure they are able to accurately price forex transactions for all counterparties, taking into account the credit risk of the customer, the portfolio of trades it has on with the dealer, market risk and settlement risk.

The more sophisticated banks have been managing counterparty credit risk over the past few years through specialised credit valuation adjustment (CVA) desks. These groups are tasked not just with pricing credit risk on forex deals, but managing that risk dynamically using credit derivatives on an ongoing basis. "The idea is to move away from the old method of credit risk management, which was really concentration risk management, where there would be a centralised credit function that simply sets credit limits by counterparty name and the business would have to stay within those credit limits. The advent of credit derivatives technology means we can be a bit smarter in the way we manage that credit risk," says Paul Anderson, head of counterparty credit trading for foreign exchange at Deutsche Bank in London.

However, the active management of counterparty risk has often focused on smaller counterparties, rather than the 10-tonne gorillas that no-one thought would go bust. Some have not bothered at all, more concerned about building up market share. The financial crisis, though, has pushed most banks to price in credit to some degree - although dealers are taking varying approaches to this.

"It seems clear that for some banks, it's literally a finger in the air and they say 'let's just add on a spread to the interbank price and give that to the corporations to protect ourselves'. Others are taking a much more sophisticated approach by using some sort of risk-adjusted return on capital model, where they are plugging in the risk associated with a particular client or a particular industry segment the client operates in and adding on a spread to the interbank pricing to effectively give themselves a cushion," says John Glover, Toronto-based director and global head of derivatives at HiFX, a forex brokerage house.

Pricing a single trade can be relatively straightforward and involves combining the market rate with a spread determined by the credit default swap (CDS) spread of the counterparty, explains Anderson (see box, Calculating a credit spread): "That's a relatively straightforward derivatives calculation for a stand-alone deal, and is based on the expected replacement cost of the contract and how likely the counterparty is to go bankrupt based on their CDS price or, where CDSs are not available, using an internal estimate."

Two years ago, at the height of the credit boom, the credit spread adjustment would have been relatively small, reflecting tight CDS levels across the market. There was also little differentiation between credits. Now, greater volatility in the foreign exchange market, combined with a significant widening of credit spreads, has meant the adjustment is much greater.

"With credit spreads where they are now, and also with foreign exchange volatilities having moved much higher, the adjustment to the forward price you have to charge for credit is much higher," says Anderson.

Before the crisis took hold, clients would have angrily questioned the quotes offered by those pricing in credit, comparing them to the levels offered by those institutions not credit-adjusting their prices. The explanation was simple, say dealers - the cheaper price may not have taken credit into account and was therefore wrong.

"You tend to find the prices of those banks charging for credit are much less competitive deal-by-deal compared to those that aren't. But they are dealing at the wrong price - it's that simple. They will act with bewilderment and surprise when a customer goes bankrupt and they realise they've been taking credit risk they haven't been paid for," says one New York-based trader.

However, clients are now beginning to recognise the need to price in credit - with the collapse of Lehman Brothers acting as a major wake-up call. "Clients might have looked at the price and thought we were trying to take mark-up on vanilla transactions. But in fact we weren't - we were just charging for the credit, and they would have been quite small adjustments at that time," says Anderson. "Now, corporates can see why we have to charge them credit and they recognise we're being very open and transparent. I had a couple of customers recently where I went through step-by-step how the valuation works."

In other words, clients are willing to pay more for vanilla forex trades now than they were before the crisis. But with some less-sophisticated banks still not fully pricing in credit, and with competitive pressures likely to emerge as more players return to the market, can this continue? After all, aren't clients concerned about price, first and foremost?

No, says Anderson. He insists customers are willing to pay a bit more to know they are trading with a bank properly charging for credit risk because there is less chance they will suddenly reach a credit limit and not be able to trade any more - something that caught out many during the difficult months of September and October.

"If a client had gone with a smaller, less sophisticated bank, then they might find they are trying to trade now, but that bank's credit lines are full because they are owed money. In comparison, if they had dealt with us and were charged a few basis points at time of trade, then I would have been managing the risk to keep the line open. So, if they had a position moving against them, I would have been accumulating CDSs on the way down, for example. That means they know they can phone through and get a price, and that's particularly valuable in times like these."

Clive Banks, London-based head of corporate derivatives marketing at BNP Paribas, agrees: "We find corporate counterparties are less price-sensitive when they know they are dealing with a safer bank. Before Lehman happened, clients were focusing on the last 0.1 of a tick, but they're not doing that anymore."

However, there are clients who are still looking for the best price - particularly now fears of a collapse of a major dealer have receded following capital injections into banks by governments across the world. As a consequence, HiFX's Glover thinks it is likely the major dealers will be losing business because of the extra cost. "And the big banks are slowing the process, as the trades have to go through the CVA desk, then the clients can't get the response they want as quickly as they want," he adds

Nonetheless, the difference in quotes between those pricing in credit and those that aren't may not be as massive as it initially seems, particularly for those clients that trade regularly with a particular dealer. For a start, most banks would take all the client's trades into account - some of which may be offsetting. Added to which, dealers would analyse their entire portfolio to determine whether that trade offers any diversification benefits.

"If I'm dealing with a big auto manufacturer that is active in three or four commodities and 10 currency pairs, then I'm getting a portfolio effect that other banks would not be getting if they were only providing forex or just aluminium hedging or whatever it happens to be," explains Anderson.

Some dealers are looking to refine this calculation further. In particular, the collapse of Lehman Brothers highlighted the dangers posed by settlement risk - Lehman had multiple legal entities, many of which defaulted at different times. The challenge for the industry is to combine all these factors to arrive at an accurate price in the quickest time possible - no mean feat.

"Most firms are set up with their market risk. Tying your market databases to your credit databases, to your legal databases, to real-time payment databases, to collateral databases, then working out how to price something that embraces all those things is a really complex task. It is the next big challenge for foreign exchange risk management," expounds one London-based head of forex.

He adds his bank plans to extend the credit charge to every counterparty it trades with - an extension of business practice before Lehman's collapse, when the dealer typically only charged for credit when trading with smaller entities. "We've been doing it for a few years, but it has typically been for smaller counterparties. Now, we are thinking about doing this for everything," he notes.

At the moment, the foreign exchange market appears to be split into two camps: those banks explicitly charging for credit risk via CVA desks, and less sophisticated institutions that set fixed credit lines and make no explicit charge for credit risk. As default rates continue to rise, however, a level playing field in terms of pricing may emerge, believes Glover. "Foreign exchange is a very competitive market place and those prices will even out. I think the way they will come into some sort of price competitiveness again is that the smaller providers will end up adding greater spreads because of the credit issue," he comments.

But what will happen when the dust settles and the danger of a counterparty default fades? Clients will likely shift back to those banks offering the best price in the quickest time. Will the major dealers be tempted to ditch their credit charge in order to remain competitive and win market share? Bankers claim they won't, adding an important lesson has been learned. "The reality is we are in a new world. This will become market practice," claims one head of structuring in London.

Calculating a credit spread

Calculating the credit spread adjustment for a single, stand-alone trade - for instance, a five-year euro/dollar forward contract - is relatively straightforward. The starting point is to calculate the expected value of the forward contract over a number of points throughout the life of the deal - for instance, every quarter. The aim is to calculate the replacement cost of the forward contract over the life of the trade.

Next, the credit valuation adjustment (CVA) desk would calculate the probability of default during each time period, using credit default swap (CDS) spreads if available. The implied default probabilities for very short-dated maturities tend to be low (because dealers can observe the counterparty's balance sheet and see if it has been generating cash and is profitable). In general, the implied default probabilities increase as the tenor of the trade increases.

Pulling together some recent option prices and assuming a CDS spread of 400 basis points, a typical CVA calculation might look like:

CVA = expected positive value x default probability

= Five-year option price x 1 - (1 - CDS spread)5

= 10% of notional x 8%

= 1.8%

However, a lot of companies currently have implied default probabilities that are lower in 2010 than they are in 2009 because the market is taking the view that if they survive the current problems, then they should be around for a while, says Paul Anderson, head of counterparty credit trading for foreign exchange at Deutsche Bank in London. As a result, the CVA charge would be more like two-thirds of the number above, or 1.2% for a five-year forward in euro/dollar, he states.

The desk would also take into account other factors that could potentially further reduce the CVA charge. For example, the group would examine other trades the counterparty has on with the bank to see if any risk can be offset.