Book 2. Credit Risk

FRM Part 2

CR 15. Counterparty Risk and Beyond

Presented by: Sudhanshu

Module 1. Counterparty Risk

Module 2. Managing, Mitigating and Quantifying Counterparty Risk

Module 1. Counterparty Risk

Topic 1. Counterparty Risk vs. Lending Risk

Topic 2. Transactions With Counterparty Risk

Topic 3. Institutions that take on Counterparty Risk

Topic 4. Counterparty Risk Terminology

Topic 1. Counterparty Risk vs. Lending Risk

• Counterparty Risk: The risk that a counterparty becomes unable or unwilling to meet its contractual obligations, which typically occurs before the contract's settlement.

  • Bilateral Risk: Both parties face the risk of the other defaulting.

  • Uncertain Value: The value of the underlying instrument is uncertain, so it's not clear which party will have a gain or a loss.

• Lending Risk: The risk that a borrower will not repay a loan.

  • Unilateral Risk: Only one party, the lender, is exposed to risk.

  • Certain Value: The principal amount at risk is generally known with reasonable certainty.

Practice Questions: Q3

Q3. Which of the following statements regarding counterparty credit risk is most accurate?

A. Counterparty risk is unilateral.

B. Over-the-counter (OTC) derivaves contain less counterparty risk than exchange-traded derivatives because the counterparty is known.

C. The precise future value of the contract is uncertain, but the counterparties are aware of whether the future value will be positive or negative.

D. Counterparty risk is typically associated with counterparty default prior to the settlement rather than default during the settlement process.

Practice Questions: Q3 Answer

Explanation: D is correct.

Counterparty risk is a bilateral risk in that both parties are unaware of the eventual value of the contract and they do not know whether they will earn a profit or loss. For exchange-traded derivatives, the counterparty is the exchange, which effectively mitigates counterparty risk. While counterparty default can happen presettlement and during settlement, counterparty risk typically applies to the risk of default prior to settlement.

Topic 2. Transactions with Counterparty Risk

• Over-the-Counter (OTC) Derivatives: OTC derivatives, unlike exchange-traded derivatives, carry counterparty risk.

  • Interest Rate Swaps: Counterparty risk is reduced compared to a regular loan because no principal is exchanged, and netting reduces the risk by only exchanging the net difference between payments.

  • Foreign Exchange Forwards: These carry significant counterparty risk due to the exchange of notional amounts and long maturities.

  • Credit Default Swaps (CDSs): These have large counterparty risks due to wrong-way risk and significant volatility. Wrong-way risk is an increase in exposure when the counterparty's credit quality worsens.

• Securities Financing Transactions: These transactions, which include repos, reverse repos, and securities borrowing and lending, carry counterparty risk.

  • Repos and Reverse Repos: Counterparty risk exists because the seller may fail to repurchase the security. This risk is mitigated by using collateral, but a risk remains that the collateral's market value could decline. A haircut is applied to the collateral to account for this potential decline in value.

Practice Questions: Q1

Q1. When considering counterparty credit risk, which of the following financial products has the largest outstanding notional amount in the marketplace?

A. Credit default swaps.

B. Foreign exchange forwards.

C. Interest rate swaps.

D. Repos and reverse repos.

Practice Questions: Q1 Answer

Explanation: C is correct.

There are two classes of financial products where counterparty risk exists: over- the-counter (OTC) derivatives and securities financing transactions such as repos and reverse repos. OTC derivatives are significantly larger with interest rate swaps comprising the bulk of the market.

Topic 3. Institutions that take on Counterparty Risk

• Institutions that take on counterparty risk through trading activities are often referred to as "derivatives players" and fall into three categories: large, medium, and small.

  • Large Derivatives Players: These are typically large banks (dealers) that trade with each other and with many clients.

    • They have a high volume of OTC derivatives and cover a wide range of asset classes.

    • They will post collateral against their positions.

  • Medium Derivatives Players: These are smaller banks or financial institutions that also have a large number of clients and a high volume of OTC derivatives trades.

    • They cover a wide range of assets but aren't as active in all of them as large players.

    • They are likely to post collateral.

  • Small Derivatives Players: These can be sovereign entities, large corporations, or smaller financial institutions with specific derivatives needs.

    • They trade with only a small number of counterparties and have few OTC derivatives on their books.

Topic 4. Counterparty Risk Terminology

• Credit Exposure (or Exposure): The potential loss a party would suffer if a counterparty defaults. It's not always the full principal amount.

• Credit Migration: The change in a counterparty's credit rating over the contract's term. Counterparties with strong credit ratings tend to deteriorate over time, while those with weak ratings tend to improve.

• Default Probability: The likelihood that a counterparty will default. It can be measured in two ways:

  • Real (Historical) Measure: The actual probability of default.

  • Risk-Neutral Measure: The theoretical market-implied probability.

• Recovery Rate: The portion of an outstanding claim that is recovered after a default.

• Loss Given Default (LGD): Calculated as 1 - recovery rate.

• Mark-to-Market (MtM): An accrual accounting measure representing the sum of the MtM values of all contracts with a specific counterparty. It equals the present value of expected inflows minus the present value of expected payments.

• Replacement Cost: The cost to replace a contract if a counterparty defaults. MtM is a measure of replacement cost, though they are not theoretically identical

Practice Questions: Q2

Q2. Liz Parker is a junior quantative analyst who is preparing a report dealing with credit migration. An excerpt of her report contains the following statements:

I. Future default probability will likely increase over time, especially for periods far into the future.

II. When computing the default probability of a counterparty under a risk-neutral measure, we need to first determine the actual default probability.

Which of Parker’s statements is (are) correct?

A. I only.

B. II only.

C. Both I and II.

D. Neither I nor II.

Practice Questions: Q2 Answer

Explanation: D is correct.

Future default probability will likely decrease over time, especially for periods far into the future. This is because of the higher likelihood that the default will have already occurred at some earlier point. In computing the default probability of a counterparty under a risk-neutral measure, one needs to compute the theoretical market-implied probability; the actual default probability applies under a real (historical) measure.

Module 2. Managing, Mitigating and Quantifying Counterparty Risk

Topic 1. Managing Counterparty Risk

Topic 2. Mitigating Counterparty Risk

Topic 3. Quantifying Counterparty Risk

Topic 4. OTC Derivatives Costs

Topic 5. X-Value Adjustment (xVA) Terms

Topic 1. Managing Counterparty Risk

• Methods to manage counterparty risk include:

  • Trading with High-Quality Counterparties: A simple and direct method that involves trading only with counterparties who have high credit ratings, such as AAA. These counterparties may not be required to provide collateral.

  • Cross-Product Netting: Aggregating transactions to reduce risk for both parties in the event of a default. Legal and operational risks must be considered, such as a netting agreement being found legally unenforceable.

    • Example from Counterparty A’s perspective:

      • Trades with positive MtM: +$20 million

      • Trades with negative MtM: -$17 million

      • Exposure with no netting: +$20 million

      • Exposure with netting: +$3 million

  • Close-Out: Immediately terminating all contracts with a defaulting counterparty. When combined with netting, an institution can offset what it owes against what it is owed.

• Collateralization (Margining): A collateral agreement that requires sufficient collateral to be posted by either counterparty to support the net exposure between them. Theoretically, this can reduce net exposure to zero.

• Walkaway Features: Allows a party to cancel a transaction if the counterparty defaults. This is advantageous if the party's MtM is negative.

• Diversifying Counterparty Risk: Limiting credit exposure to any single counterparty by trading with more counterparties.

• Exchanges and Centralized Clearinghouses: These entities take on the role of the counterparty, removing counterparty risk from trades. This may redistribute, rather than eliminate, the risk.

Topic 1. Managing Counterparty Risk

Topic 2. Mitigating Counterparty Risk

• Netting: Required payments are computed and offset so that only the party that owes a net amount makes a payment.

• Collateralization: Taking collateral equal to or greater than the notional amount can, in theory, eliminate all counterparty risk. However, it comes with administrative costs, liquidity risk, and legal risk.

• Hedging: Using credit derivatives to reduce counterparty exposure to one's own clients. This generates market risk.

• Central Counterparties (CCPs): Exchanges and clearinghouses act as the counterparty, centralizing risks, settling transactions, and reducing bilateral risks. This can, however, generate operational, liquidity, and systemic risks because it reduces the incentive for parties to monitor counterparty risk.

Practice Questions: Q1

Q1. Ondine Financial, Inc., (Ondine) uses a variety of techniques to manage counterparty risk. It has entered into an interest rate swap with Scarbo, Inc. (Scarbo). Currently, Ondine’s position in the swap has a –$1 million mark-to-market value. Based on the information provided, which of the following credit risk mitigation techniques would be most advantageous to Ondine if Scarbo
defaults?

A. Close-out.

B. Collateralization.

C. Netting.

D. Walkaway.

Practice Questions: Q1 Answer

Explanation: D is correct.

Because Ondine currently has a negative mark-to-market value and the counterparty is defaulting, Ondine is able to cancel the transaction while it is “losing.” Netting and close-out would require Ondine to make a payment because it would owe a net amount of $1 million. Collateralization is not relevant in this scenario.

Practice Questions: Q2

Q2. Which of the following methods of mitigating counterparty risk is most likely to generate systemic risk?

A. Netting.

B. Collateral.

C. Hedging.

D. Central counterparties.

Practice Questions: Q2 Answer

Explanation: D is correct.

Mitigating counterparty risk often leads to the generation of other types of risk. In the case of central counterparties, systemic risk is created as counterparty risk has been centralized with a limited amount of groups. If one of these groups fails, a substantial shock may be experienced by the financial system as a whole.

Topic 3. Quantifying Counterparty Risk

• Counterparty risk is quantified at three levels:

  • Trade level: Considers the nature of the specific trade and related risk factors.

  • Counterparty level: Accounts for risk mitigation factors like netting and collateral for each individual counterparty.

  • Portfolio level: Considers the overall counterparty risk for all trades, acknowledging that only a small percentage of counterparties are likely to default.

• Credit Value Adjustment (CVA):

  • The portion of a derivative's price that accounts for counterparty risk.

  • Examines counterparty risk at both the trade and counterparty levels.

  • Aims to minimize the number of counterparties to maximize netting benefits.

  • Credit limits, in contrast, act at the portfolio level to limit exposures and aim to maximize the number of counterparties for greater diversification. CVA and credit limits are complementary.

Topic 4. OTC Derivatives Costs

• The lifetime economic costs of OTC derivatives depend on whether the transaction has a positive or negative MtM.

  • Positive MtM (in-the-money): The transaction is in the money for the party. This gives rise to counterparty risk and funding costs on any uncollateralized portion. The counterparty chooses the type of collateral to post.

  • Negative MtM (out-of-the-money): The transaction is out of the money for the party. This results in counterparty risk from the party’s own potential for default. A funding benefit may arise from any collateral that is not posted. The party itself chooses the type of collateral to post.

  • Both Scenarios: Funding costs are associated with the capital and initial margin needed for the transaction.

Topic 5. X-Value Adjustment (xVA) Terms

• xVA terms capture the impact of counterparty risk, collateral, funding, and capital. While generally representing a cost, some components may provide a benefit.

  • Credit Value Adjustment (CVA): The cost of counterparty risk.

  • Debt Value Adjustment (DVA): Defines counterparty risk from the party's own perspective.

  • Funding Value Adjustment (FVA): The cost or benefit from funding a transaction.

  • Collateral Value Adjustment (ColVA): The cost or benefit from embedded options and other terms in collateral agreements.

  • Capital Value Adjustment (KVA): The cost of holding capital over a transaction's duration.

  • Margin Value Adjustment (MVA): The cost of posting margin over a transaction's duration.