Download ice clear credit llc exhibit h: portfolio approach to cds margining and

ICE CLEAR CREDIT LLC
EXHIBIT H: PORTFOLIO APPROACH TO CDS MARGINING AND INDEX
DECOMPOSITION METHODOLOGY
ICE Clear Credit Portfolio Approach to CDS Margining and Index Decomposition
Methodology
1.
Overview
To provide efficient margin benefits for portfolios containing offsetting positions in both
Index CDS and single-name CDS, index products are first decomposed to produce single-name
index-derived positions with notional sizes corresponding to their weight in the index. These
new, “synthetic,” single-name positions have a coupon which is the same one as the index from
which the single-name positions have been derived. Another set algorithm identifies long-short
(index/single-name) pairs with the same expirations. Preference is given to offsets that minimize
curve risk. If the notional amounts in the single-name products correspond to opposite
(offsetting) positions, the index-derived notional amount is reduced by the available opposite
single-name positions without changing the direction of any single-name positions. If the
opposite index-derived or outright single-name positions do not have the same maturities, the
notionals of the outright positions are expressed as equivalent notional amounts of the
corresponding index-derived positions in such a way that the Risky PV01 (the present value of 1
(one) basis point of risky annuity paid or received, until the earlier of a credit event, or the
maturity of the CDS contract) remains constant after change of notional. Once the opposite
positions have the same maturities, offsets are provided. If either the long or the short positions
are in excess, the unconsumed notional amounts are expressed back at their original maturities.
In summary, the effect of the index decomposition methodology is to start with the actual
portfolio and to end with a “reduced” position in index and single-name products. The reduced
portfolio is then subjected to Spread Risk Requirements as explained in subsection 2. below.
The portfolio decomposition methodology provides benefits by recognizing hedges and
diversification benefits within portfolios. Index replication benefits are considered with explicit
modeling of basis risk and basis risk requirements are introduced. The risk management
approach establishes stress loss analysis at selected quantile levels as the main risk methodology
used for estimating risk margin requirements, Guaranty Fund size, and Guaranty Fund
allocations.
2.
Spread Risk Requirements
One of the main components of a risk management model is the univariate distribution
that describes the random realizations of a price determining factor. The common models are
usually first calibrated by estimating an appropriate distribution to a time series of past
realizations of the driving factor, and subsequently this distribution is used for risk management
purposes.
The main price determining factor of cleared CDS instruments is the default probability
of the underlying name(s). Since default probability is not directly observed in the marketplace,
a common practice is to model the market implied credit spreads.
To arrive at plausible credit spread scenarios, ICE Clear Credit models the realizations of
credit spread log-returns. The log-return modeling approach readily accounts for the nonnegativity of credit spreads. It is assumed that credit spread log-returns are drawn from a heavytailed skewed distribution as empirical analysis indicates. The distribution used is assumed to be
relatively static in the sense that it does not change over a short period of time. The only timevarying (dynamic) distribution parameter is the scale. These specific assumptions are introduced
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to provide more stable and more easy-to-reproduce numerical results. The assumptions can be
readily relaxed if necessary.
3.
Liquidity Charges
The portfolio bid/offer requirements, liquidity charges (“LCs”), are estimated prior to the
index decomposition. For all long protection index positions, the LCs are estimated by
considering the current default bid/offer width values for Level II Conditions as reviewed by the
CDS Risk Committee. All short protection index positions are subject to LCs estimated with the
respective bid/offer width values corresponding to Level III Conditions.1
The bid/offer requirements for long-short positions in the same index series and different
tenors are subject to the single name bid/offer approach. The estimated LC for each series within
the index risk factor is taken with the sign of the net notional amount for that series. The
resulting numerical values for all series are added together, and the final index risk factor LC is
the negative of the absolute value of the sum. The total portfolio LC is the sum of the individual
index-specific LCs and the single name LCs.
Since the LCs for index and single name instruments are not subject to any portfolio
benefits and they scale with the spread levels, the overall basis risk requirements are dynamic
and increase during periods of spread widening. The model response is consistent with the
observed market behavior of widening basis upon spread widening. The methodology provides
dynamic bid/offer requirements, and thus dynamic basis risk requirements, to reflect the
increased risk during periods of worsening economic conditions.
4.
Concentration Charges for Large Positions
Large position requirements, referred to as concentration charges, apply to long and short
protection positions that exceed a predefined risk factor specific notional threshold level. The
concentration charge threshold reflects the market depth and liquidity for the considered risk
factor. The threshold is established by ICE CDS Risk Management staff, in consultation with
ICE CDS Risk Committee.
5.
Jump-to-default Charges
The CDS risk management approach incorporates a jump-to-default requirement for each
single name risk factor for sold protection positions. The portfolio jump-to-default requirement
is bounded by the potential liabilities associated with three simultaneous credit events for some
assumed single name-specific minimum recovery rate. An expected minimum recovery rate is
established for every industry sector by ICE Clear Credit and reviewed quarterly by the ICE
Clear Credit CDS Risk Committee.
6.
Portfolio Basis Risk Requirements
As index-derived single name positions and outright single name positions are offset,
additional basis risk requirements are introduced due to the fact that the indices are more actively
traded and thus the preferred instruments to express changing views about the credit market as a
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Level I, II, and III Conditions represent observed bid/offer width reflecting different market conditions Level I representing the most actively traded state and Level III the most volatile trading state (wider bid/offer
widths). The bid/offer width values used for the LC estimations are reviewed quarterly by the ICE Clear Credit Risk
Committee.
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whole, or even about specific single name components of the indices. Consequently, the price of
the index instruments might be moving faster than (ahead of) the single names, and thus creating
a greater difference between the quoted spread and the fair (intrinsic) spread. In addition, the
coupon standardization introduces new aspects to the basis risk concepts due to the uncertainty
of single name coupon choice by the market place, and/or by the improved ability to replicate the
streams of future payments. The liquidity of the index provides lower risk premium compared to
less actively trade single name instruments.
7.
Portfolio Interest Rate Sensitivity Requirement
To account for possible risk associated with changes of the interest rate default-free
discount term structure used to price all CDS instruments, the model considers parallel shifts of
the discount term structure used within the ISDA model. Up and down parallel shifts of the
current discount “curve” are utilized to uncover potential portfolio losses. The worst portfolio
loss resulting from the difference between the values of the portfolio estimated at the current
discount term structure and at either of the simulated ones establishes the interest rate sensitivity
requirement. The parallel shifts will be associated with the equivalent of 5-day 99% expected
shortfall for the rate changes for the tenor associated with the longest maturity cleared CDS
instruments (i.e., currently 10-Year). The parallel interest rate shifts are viewed as the first order
sensitivity drivers. The parallel shift parameters, in general, are asymmetric and produce nonnegative discount rates. Currently, the up-shift is estimated to be 45 basis points, and the downshift is estimated to be 35 basis points. The resulting discount curves are non-negative by
construction.
The magnitudes of the considered scenarios, as designed to reflect the current interest rate
sensitivity requirement levels and their variabilities, are subject to review and changes, if
necessary, upon consultation with the Risk Committee.
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