A Guide to Modelling Counterparty Credit Risk

Electronic copy available at: http://ssrn.com/abstract=1032522GLOBAL ASSOCIATION OF RISK PROFESSIONALS16 JULY/AUGUST 07 ISSUE 37 C ounterparty credit risk is the risk that the counterparty to a financial contract will default prior to the expiration of the con- tract and will not make all the payments required by the contract. Only the con- tracts privately negotiated between coun- terparties — over-the-counter (OTC) derivatives and security financing transactions (SFT) — are subject to counterparty risk. Exchange-traded derivatives are not affected by counterparty risk, because the exchange guarantees the cash flows promised by the derivative to the counterparties. 1 Counterparty risk is similar to other forms of credit risk in that the cause of economic loss is obligor’s default. There are, however, two features

that set coun- terparty risk apart from more traditional forms of cred- it risk: the uncertainty of exposure and bilateral nature of credit risk. (Canabarro and Duffie [2003] provide an excellent introduction to the subject.) In this article, we will focus on two main issues: modelling credit exposure and pricing counterparty risk. In the part devoted to credit exposure, we will define credit exposure at contract and counterparty levels, introduce netting and margin agreements as risk management tools for reducing counterparty-level exposure and present a framework for modelling credit exposure. In the part devoted to pricing, we will define credit value adjustment (CVA) as the price of counterparty credit risk and discuss approaches to its calculation. Contract-Level Exposure If a counterparty in a derivative contract defaults, the bank must close out its position with the defaulting counterparty. To determine the loss arising from the counterparty’s default, it is convenient to assume that the bank enters into a similar contract with another counterparty in order to maintain its market posi- tion. 2 Since the bank’s market position is unchanged after replacing the contract, the loss is determined by the contract’s replacement cost at the time of default. A Guide to Modelling Counterparty Credit Risk What are the steps involved in calculating credit exposure? What are the differences between counterparty and contract-level exposure? How can margin agreements be used to reduce counterparty credit risk? What is credit value adjustment and how can it be measured? Michael Pykhtin and Steven Zhu offer a blueprint for modelling credit exposure and pricing counterparty risk. Electronic copy available at: http://ssrn.com/abstract=1032522 GLOBAL ASSOCIATION OF RISK PROFESSIONALS GLOBAL ASSOCIATION OF RISK PROFESSIONALS 17 JULY/AUGUST 07 ISSUE 37 If the contract value is negative for the bank at the time of default, the bank • closes out the position by paying the defaulting coun- terparty the market value of the contract; • enters into a similar contract with another counterparty and receives the market value of the contract; and • has a net loss of zero. If the contract value is positive for the bank at the time of default, the bank • closes out the position, but receives nothing from the defaulting counterparty; • enters into a similar contract with another counterparty and pays the market value of the contract; and • has a net loss equal to the contract’s market value. Thus, the credit exposure of a...

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