Counterparty Credit Risk

by Jon Gregory (Independent Trainer and Consultant)

• ISBN13: 9780470685761
• ISBN10: 047068576X
• Format: Hardcover
• Copyright: 2010-01-01
• Publisher: Wiley

Summary

Counterparty risk is traditionally thought of as credit risk between derivatives counterparties. Since the credit crisis of 2007 onwards and the failures of large prestigious institutions such as Bear Sterns, Lehman Brothers, Fannie Mae and Freddie Mac, counterparty risk has been considered by most to be the key financial risk. Historically, many financial institutions limited their counterparty risk by only trading with the most sound counterparties. Market participants tended to underestimate its magnitude as a result of the implicit "too big to fail" assumption and only a few large dealers invested heavily in assessed counterparty risk. This is set to change.There are many solutions to the current counterparty risk problems, all of which mitigate the risk, however best mechanism for control is a full understanding of all aspects of counterparty credit risk, including the many possible risk mitigants. Only as more market participants become knowledgeable will the control of this new dimension of financial risk management will become practical.This book will be a complete guide to the area of counterparty credit risk. It will present a thorough description of this subject for readers familiar with basic financial markets. The implications and issues arising from the credit crisis will be a particular focus and specific relevant events (Lehman Brothers, Bear Stearns) will be discussed. The book will cover all important areas peripheral to counterparty credit risk such as collateral management, liquidity and credit derivatives. Mathematical aspects (pricing) will be covered but the aim is to keep these concepts as simple as possible and separate any complex formulas from the main text in appendices.

Table of Contents

Acknowledgements

List of Spreadsheets

List of Abbreviations

Introduction

Setting the Scene

Financial risk management

The failure of models

The derivatives market

Risks of derivatives

Counterparty risk in context

Defining Counterparty Credit Risk

Introducing counterparty risk

Components and terminology

Controlling counterparty credit risk

Quantifying counterparty risk

Metrics for credit exposure

Summary

Characterising exposure for a normal distribution

Mitigating Counterparty Credit Risk

Introduction

Default-remote entities

Termination and walkaway features

Netting and close-out

Netting and exposure

Collateral

The mechanics of collateralisation

Is risk mitigation always a good thing?

Summary

EE of independent normal variables

Quantifying Counterparty Credit Exposure, I

Quantifying credit exposure

Typical credit exposures

Models for credit exposure

Netting

Exposure contributions

Summary

Semi-analytical formula for exposure of a forward contract

Computing marginal EE

Quantifying Counterparty Credit Exposure, II: The Impact of Collateral

Introduction

The impact of collateral on credit exposure

Modelling collateral

Full collateralisation

The risks of collateralisation

Summary

Calculation of collateralised PFE

Calculation of collateralised netted exposure with collateral value uncertainty

Mathematical treatment of a collateralised exposure

Overview of Credit Risk and Credit Derivatives

Defaults, recovery rates, credit spreads and credit derivatives

Credit derivatives

Credit default swaps

Estimating default probability

Portfolio credit derivatives

Defining survival and default probabilities

Pricing formulas for CDSs and risky bonds

Pricing of index tranches

Pricing Counterparty Credit Risk, I

Pricing counterparty risk

Pricing new trades using CVA

Bilateral counterparty risk

Summary

Deriving the equation for credit value adjustment (CVA)

Approximation to the CVA formula in the case of no wrong-way risk

Approximation linking CVA formula to credit spread

Specific approximations to the CVA formula for individual instruments

Calculation of CVA increase in the presence of netting

Deriving the equation for bilateral credit value adjustment (BCVA)

Approximation linking CVA formula to credit spreads for bilateral CVA

Deriving the equation for BCVA under the assumption of a bilateral walkaway clause

Pricing Counterparty Credit Risk, II: Wrong-way Risk

Introduction

Wrong-way risk

Measuring wrong-way risk

Counterparty risk in CDSs

Counterparty risk in structured credit

Counterparty risk and gap risk

Super senior risk

Summary

Computing the EE of a typical forward exposure with correlation to a time of default

Formula for a risky option

Formula for pricing a CDS contract with counterparty risk

Pricing of a leveraged super senior tranche

Hedging Counterparty Risk

Introduction

Hedging and pricing

Hedging a risky derivative position

Traditional hedging of bonds, loans and repos

Risk-neutral or real parameters?

Components of CVA

Recovery risk

Static hedging

Dynamic credit hedging

Exposure

Cross-dependency

Aggregation of sensitivities

Summary

Example of calculation of CVA Greeks

Portfolio Models and Economic Capital

Introduction

Joint default

Credit portfolio losses

The impact of stochastic exposure

Special cases of alpha

Credit migration and mark-to-market

Summary

Credit portfolio model

Simple treatment of wrong-way risk

Counterparty Risk, Regulation and Basel II

Introduction

The birth of Basel II

Basel II Framework for fixed exposures

Exposure at default and Basel II

Basel II internal model method

Basel II and double-default

Summary

Effective remaining maturity

The asset correlation and maturity adjustment formulas in the advanced IRB approach of Basel II

Netting and collateral treatment under the current exposure method (CEM) of Basel II

Definition of effective EPE

Double-default treatment of hedged exposures in Basel II

Managing Counterparty Risk in a Financial Institution

Introduction

Counterparty risk in financial institutions

Insurance company or trading desk?

How to calculate credit charges

How to charge for counterparty risk

Summary

Counterparty Risk of Default-remote Entities

The triple-A counterparty

The value of monolines and CDPCs

Summary

Simple model for a credit insurer

The valuation of credit insurer purchased protection

The Role of a Central Counterparty

Centralised clearing

The viability of centralised clearing

Conclusions

The Future of Counterparty Risk

A counterparty risk revolution?

Controlling credit exposure

Collateral management

The too-big-to-fail concept

Credit value adjustment (CVA)

Hedging

Credit derivatives

Central counterparties

The overall challenge

Glossary

References

Index

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