Counterparty credit risk

Roman Kornyliuk,
Ph.D. in Finance
December 2012
 Content
• Counterparty credit risk (CCR) definition
• CCR management tools
• CCR indicators
• CCR and Basel II
• CCR and Basel III
CCR DEFINITION
 CCR definition
• Counterparty credit risk – the risk that the counterparty to
a financial contract will default prior to the expiration of
the contract and will not make all the payments required
by the contract.

• Only the contracts privately negotiated between

counterparties - over-the-counter (OTC) derivatives and
security financing transactions (SFT) – are subject to
counterparty risk.

• Exchange-traded derivatives are not affected by CCR

because of the exchange guaranties
 CCR specific nature:
There are two features that set CCR apart from
more traditional forms of credit risk:

• the uncertainty of exposure

since the contract value changes unpredictably over time as the
market moves, only the current exposure is known with certainty,
while future exposure is uncertain.

• the bilateral nature of credit risk

since either counterparty can default, counterparty risk is bilateral.
CCR MANAGEMENT TOOLS
 CCRM mitigation tools
Counterparty credit exposure can be reduced by:

• Trading with high-quality counterparties

• Diversification. Spreading exposure across different

counterparties.

• Netting. Being legally able to offset positive and negative contract

values with the same counterparty in the event of their default.

• Collateralisation. Holding cash or securities against an exposure.

• Hedging. Trading instruments such as credit derivatives to reduce

exposure and counterparty risk.
 CCRM mitigation tools

Other forms of traditional counterparty credit risk management (CCRM)

include:

• the development of a broad set of risk metrics,

• ongoing monitoring and evaluation of exposures such as:

- stress testing on a consolidated basis over a range of suitably

stressful scenarios;
- due diligence to understand the strategies and history of the
counterparty;
- limits on specific trades, exposures, or concentrations;
- well-defined processing arrangements and settlement protocols.
CCR INDICATORS
 CCR indicators:

Exposures: CE, PFE, EE, EEE, Effective EE and EPE

Credit risk indicators: EAD, PD, LGD, Recovery rate

Credit Valuation Adjustment (CVA)

 CE, PFE
CE (Current Exposure)
- the larger of zero market value of a transaction or portfolio of transactions
within a netting set with a counterparty that would be lost upon the default of
the counterparty, assuming no recovery on the value of those transactions in
bankruptcy.
- Current exposure is also called Replacement Cost.

PFE (Potential Future Exposure)

- the maximum positive exposure estimated to occur on a future date at a high
level of statistical confidence.

Used in: measuring CCR exposure against counterparty credit limits.

CE,PFE
 EE, Effective EE
EE (Expected Exposure)
- the probability-weighted average exposure estimated to
exist on a future date.

EEE (Effective Expected Exposure) at a specific date

- the maximum expected exposure that occurs at that date or
any prior date. Simply, non-decreasing EE. We need EEE
because EE not capture properly rollover risk

Used in: calculating the economic capital

EE EE, Effective EE

- Only the positive exposures on the given date are averaged

-The average of the negative exposures is the expected exposure of the other
counterparty to the contract.
EE EE vs. PFE

- EE will be greater than the expected MtM since it concerns only the positive MtM values
EE EE and Effective EE

Effective EE is non-decreasing EE
 EPE, Effective EPE
EPE (Expected Positive Exposure )
- the time-weighted average of individual expected exposures estimated
for given forecasting horizons (e.g. one year)

Effective EPE (Effective Expected Positive Exposure)

- the average of the effective EE over one year or until the maturity of
the longest-maturity contract in the netting set whichever is smaller.

Used in: calculating the economic capital

EPE, Effective EPE
 EAD
In the calculation of economic capital for CCR under Basel II three main risk
parameters are used:
- Exposure at Default,
- Loss Given Default,
- Probability of Default

EAD (Exposure at Default)

- is the expected total amount in currency of the firms counterparty credit
exposure in the event the counterparty defaults.
- It is often measured for a one year period or over the period until
maturity if this is less than one year. CCR generally refers to the bilateral
credit risk of transactions with uncertain exposures that can vary over
time with the movement of underlying market factors.
- Basel II provides three alternative methods for calculating EAD. However,
EPE is generally regarded as the appropriate EAD measure to determine
the EC for CCR.
 LGD
LGD (Loss Given Default)
- is the loss a firm suffers as a result of the counterparty to an
OTC derivative contract defaulting. It is therefore the fraction
of EAD that will not be recovered following a default.

- Most banks calculate the LGD for an entire portfolio based on

cumulative losses and exposure.

- A term usually used in the modeling of credit default swaps is

recovery rate of default. It is one minus LGD.

- LGD is assumed to stay constant over time in some industry

sectors. However, LGD is in practice stochastic and is subject to
both idiosyncratic (firm specific) and systematic risks .
 PD
PD (Probability of Default)
- The probability of default gives the likelihood that a
counterparty to the OTC derivative contract defaults.

- It is estimated for a single contract or a portfolio of OTC

transactions depending on the credit quality (rating) of the
counterparty. Unlike LGD, it doesnt depend on the
transaction characteristics of the contract (example,
collateral).

- Basel II requires that the PD be calculated over a one year

horizon. PD of a counterparty may vary with macroeconomic
conditions or the business cycle, also it’s depend on credit
rating of the counterparty.
 CVA
CVA (Credit Valuation Adjustment)

• CVA — the monetized value of counterparty credit risk for a

portfolio of over the counter (OTC) derivatives

• CVA is the market value of counterparty credit risk: the

difference between the risk-free portfolio value and the true
portfolio value that takes into account the counterparty’s
default.

• Therefore CVA is need to calculate the fair value of derivative

position
 CVA
• For years, the standard practice in the industry was to mark
derivatives portfolios to market without taking the CCR into
account. All cash flows were discounted by the LIBOR curve, and
the resulting values were often referred to as risk-free values.

• However, the true portfolio value must incorporate the possibility

of losses due to counterparty default.

• The credit valuation adjustment (CVA) has become an integral

part of accounting rules and Basel III.

• Roughly two-thirds of CCR losses [credit crisis risk losses] were

due to CVA losses and only one-third were due to actual defaults’
(Basel Committee on Banking Supervision).
 CVA: unilateral vs. bilateral

• CVA can be defined either on a unilateral or a bilateral basis.

• Unilateral CVA assumes that the institution which does the CVA analysis (the
bank) is default-free. It gives the market value of future losses caused by the
counterparty’s potential default.

• Bilateral CVA takes into account the possibility of both the counterparty and
the bank defaulting. This is required for an objective fair value calculation
since both the bank and the counterparty require a premium for the credit
risk they are bearing.

• Unilateral CVA is now part of Basel III, while bilateral CVA is more in line with
the market practice at top financial institutions for pricing and hedging, as
well as accounting rules.
BASEL II
 CCR and Basel II
Minimum Capital Requirements for Counterparty Credit Risk (1)

IRB Approach: Regulatory Capital ( C ) is calculated according to:

where
K(PD,LGD) is default-only capital factor that is calculated from PD &LGD according to:

MA(PD,M) is maturity adjustment:

 CCR and Basel II
The major difficulty in applying rules to counterparty risk in SFT and
OTC derivatives is:
• the uncertainty of future exposure
• and complexity associated with calculation of future exposure
distribution.

Basel Committee describes methods of calculating EAD For OTC

derivatives, these methods include:

- Current Exposure Approach,

- Standardized Approach,
- Internal Rating-Based Approach (IRBA)
in the order of increasing sophistication
 CCR and Basel II
1. Current Exposure Approach:
EAD = RC + Add-on
where
RC - the current replacement cost;
Add-on - the estimated amount of the potential future exposure (PFE);

For a portfolio of transactions covered under a legally enforceable bilateral netting agreement,
RC - simply the net replacement cost across derivative contracts in the netting set, given by the larger of
net portfolio value or zero.
Add-on - is calculated under the Basel I formula:

where
Add-oni - the Add-on for transaction i
NGR - the ratio of the current net replacement cost (RC under full netting) to the current gross
replacement cost (RC under no netting) for all transactions within the netting set.
 CCR and Basel II
2. Standardized Approach:
• The standardized method in Basel II was designed for those banks that do not qualify to
model counterparty exposure internally but would like to adopt a more risk-sensitive
approach than the CEM.

where
NCV - the current market value of transactions in the portfolio net the
current market value of collateral assigned to the netting set;
NRPj - the absolute value of net risk position in the hedging set j;
CCFj - the credit conversion factor with respect to the hedging set j, that
converts the net risk position in the hedging set into a PFE measure.
 CCR and Basel II
3. Internal Rating-Based Approach
• the most risk-sensitive approach for the exposure at default (EAD) calculation available under
the Basel II framework.

EAD = α × Effective_EPE
where
Effective EPE - the Effective Expected Positive Exposure calculated for each
netting set from the expected exposure (EE) profile,
α - a multiplier.
 CCR and Basel II
Calculating EPE
Typically, banks that model exposure internally compute
exposure distributions at a set of future dates {t1, t2 … tK } using
Monte Carlo simulations.

For each simulation date t, the bank computes expectation of

exposure EEK as a simple average of all Monte Carlo realizations
of exposure for that date.

EPE is defined as the average of the EE profile over the first year.
Practically, it is computed as the weighted average of EEK.
 CCR and Basel II
There are three main components in calculating the distribution of
netting-set-level or counterparty-level credit exposure:

• Scenario generation: Future market scenarios are usually

simulated for a fixed set of simulation dates using evolution
models of the risk factors.

• Instrument valuation: For each simulation date and for each

realization of the underlying market risk factors, instrument
valuation is performed.

• Aggregation: For each simulation date and for each realization of

the underlying market risk factors, instrument values are added
within each netting set to obtain netting set portfolio value.
Scenario generation process
BASEL III
 Basel III requirements
• CVA Capital Charge
• Stressed EEPE Reports
• Measure Wrong Way Risk
• Independent Review of CCR
• Counterparty Risk Factors
• Stressed PD's
• Collateral Reporting
 CCR and Basel III
• Basel II :
counterparty credit risk was capitalized for default risk only.
Mark-to-market losses due to CVA were not directly
capitalized.

• Basel III:
the CVA risk capital charge was added

WHY?
During the financial crisis roughly two-thirds of losses
attributed to counterparty credit risk were due to CVA losses
and only about one-third were due to actual defaults.
 CCR and Basel III

• The credit valuation adjustment (CVA) has

become an integral part of accounting rules
and Basel III.

• The Basel III Accord introduced a new capital

charge for CVA risk, in addition to the capital
charge for counterparty default risk in Basel II.
 CVA capital charge (Basel III)
internal models method:
The CVA capital charge is given by:

where:
K - the regulatory multiplier (typically set to 3),

deltaCVA = CVAd - CVA0 ,

CVAd - the CVA d days in the future (d = 10).

SVaR denotes the stressed VaR calculated with stressed exposures and spread
scenarios coming from a crisis period.
 CVA (Basel III)
internal models method:
The CVA is given by:

where:
LGDMKT - the loss given default for the counterparty (1 – recovery),
EEi - the expected (unconditional) exposures at each time,
Si - the counterparty’s spread.
LIMITATIONS TO COUNTERPARTY CREDIT RISK
MANAGEMENT
 Market failures limit CCRM
To assess the question of why CCRM might prove insufficient, it is
useful to examine potential market failures (in a sense of
deviations from a perfectly competitive, full-information economy
that efficiently allocates resources) in the provision of credit.

These market failures include

• agency problems,
• externalities,
• free-rider problems,
• moral hazard,
• and coordination failures.
 >>> agency problem

• An agency problem exists when participants

have different incentives, and information
problems prevent one party (the principal)
from perfectly observing and controlling the
actions of the second (the agent).
 >>> externality

• An externality is an impact of one party’s action on

others who are not directly involved in the
transaction.

If the potential exposure amounts to a significant

share of bank capital, then a large shock to hedge
funds could weaken banks and impair their ability
to provide liquidity to the financial system or credit
to borrowers.
 >>> competition
• The apparent profits to be earned in this
business may create competitive pressures that
weaken credit risk mitigation practices.

• Bernanke (2006), for example, discuss how

competition for new hedge fund business may be
eroding CCRM, such as through lower than
appropriate fees and spreads, or inadequate risk
controls such as lower initial margin levels,
collateralization practices, or exposure limits.
 >>> moral hazard
• Moral hazard refers to changes in behavior in response to
redistribution of risk, for example, insurance may induce

• risk-taking behavior if the insured does not bear the full

consequences of bad outcomes. In financial markets, the

• question of moral hazard from conjectural guarantees by

the government—the implicit promise to bail out certain
bank

• creditors—may apply to the largest commercial banks, but

it does not apply to hedge funds.
 >>> free-rider problem

• Consider, for example, a large hedge fund that has exposures

with many banks, all of whom benefit from the health of the
hedge fund.

• While in principle every bank should monitor its exposure

and limit excess risk-taking by the hedge fund, each bank also
has an incentive to free-ride by reducing its CCRM and
enjoying the benefits of the CCRM of the other banks.

• This is a classic example of “tragedy of the commons,” where

private markets may underprovide the public good and create
a rationale for official sector intervention.
 References

1. Basel III. Counterparty credit risk – FAQ. – BCBS. - November

2011.
2. Bekele S. Counterparty credit risk. – 2009.
3. Brigo D. Counterparty Risk FAQ. – 2011.
4. Gregory J. Counterparty credit risk: The New Challenge for
Global Financial Markets. – Wiley. – 2010.
5. Kambhu J., Schuermann T., Stiroh K. Hedge Funds, Financial
Intermediation, and Systemic Risk // FRBNY Economic Policy
Review. - December 2007.
6. Pykhtin M, Zhu S. Measuring Counterparty Credit Risk for
Trading Products under Basel II. – 2006.