Counterparty Credit Risk

I COUNTERPARTY CREDIT RISK BMI MASTERS THESIS April, 2009 Seyoum Zeleke Bekele SUPERVISOR: Erik Winands Faculty of Science Business Mathematics and Informatics De Boelelaan 1081a 1081 HV Amsterdam II I Preface This master‟s thesis is part of the BMI curriculum that is required to be delivered by the student in order to complete the program. A BMI thesis is basically a research project around a specific problem statement. The thesis is based on already available literature. However, the student can make use of computer generated data and simulation results. The thesis is written for an expert manager who has a general expertise in the subject area. It is assumed that the thesis has a practical benefit for the manager. I

would like to thank my supervisor, Erik Winands, for helping me choose the topic and guiding me throughout the writing of this thesis. I thank also Drs. Annemieke van Goor-Balk for providing me with necessary information and help facilitate my work. II Abstract One of the risks banks face is counterparty credit risk, which is the risk that results when a counterparty is unable or unwilling to meet agreed obligations. In particular, banks involved in over-the-counter (OTC) securities and derivatives transactions face this risk. In light of the current global financial crisis, which resulted in the bankruptcy of large banks, it is of great importance to give more attention to methods that help mitigate counterparty credit risk as well as to the modeling, measuring and pricing of this risk. According to IMFs Global Financial Stability Report (2008), there is a persistent and increasing concern about counterparty credit risks (CCR). This risk has increased significantly threatening the existence of big banks in a chain reaction as a result of a default of a counterparty. Financial institutions are required to have a minimum capital to shield against the default risk. Hence modeling CCR is important in order to determine the appropriate economic capital needed. In this thesis I will discuss in brief recent works about the modeling and pricing of CCR. This includes bringing together different modeling and measuring methods both at counterparty as well as portfolio level. The thesis also discusses the minimum required capital when one engages in over-the-counter (OTC) derivative contracts and techniques used to reduce exposure to this risk. The thesis has four main parts followed by a conclusion. In the first part Counterparty Credit Risk is described. Some OTC products will also be briefly discussed. Finally the risk measures used are defined. The second part introduces the general modeling and measuring of Counterparty Credit Risk and describes or analyzes the difference on the models used. Although it will not be in depth analysis models both at a counterparty levels and portfolio level will be presented. In addition to that a risk mitigating techniques in practice will be highlighted. In the third part I will focus on the credit derivative product called credit default swap (CDS). Here a recent model for CDS will be presented. Also pricing of the CDS using Monte Carlo simulation is discussed. The fourth part discusses the economic capital (EC), a measure of counterparty...

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