Close-Out Risk Evaluation (CORE) : A New Risk Management Approach for Central Counterparties

This paper introduces the CORE methodology for managing risk of multi-market central-counterparties. CORE generalizes the classical SPAN method of stress scenarios by incorporating explicitly market liquidity of listed instruments and modeling the liquidity pro file of OTC instruments and the liquidation-by-auction mechanism. In the presence of liquidity constraints, there is a difference between unrealized ex ante mark-to-market losses, say, on the date of default, and realized losses after liquidation is concluded. This leads us to formulate an optimal liquidation strategy for portfolios under stress-scenarios and liquidity constraints. We formulate this problem as the maximization of an objective function which involves a sequence of potential transient losses (realized and mark-to-market) along the liquidation period. The objective function is designed to minimize transient losses and thus reduce funding liquidity requirements for the CCP along the liquidation period; it is shown to be robust with respect to liquidation-by-auction assumptions and to liquidity constraints.Computationally, we formulate CORE as a Linear Programming problem under linear constraints, which can be solved using high-performance large-scale optimization packages such as CPLEX and GUROBI. We illustrate the computation of the CORE strategy on a series of sample portfolios and compare the anticipated gains in reserve capital due to CORE for the di fferent examples. Preliminary tests indicate that improvements of between 20 and 60% can be realized by applying optimal liquidation schedules which match instruments with common risk factors according to their liquidity profiles in the liquidation process