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Counterparty Credit Risk

Counterparty credit risk (CCR) refers to the risk that a counterparty to a bilateral financial derivative contract may fail to fulfill its contractual obligation causing financial loss to the non-defaulting party. It will be incurred in the event of default by a counterparty. Only over-the-counter (OTC) derivatives and financial security transactions (e.g., repo) are subject to counterparty risk. If one party of a contract defaults, the non-defaulting party will find a similar contract with another counterparty in the market to replace the default one. That is why counterparty credit risk sometimes is referred as replacement risk. The replacement risk is the MTM value of a counterparty portfolio at the time of the counterparty default.<br><br>Counterparty credit risk measurement is credit exposure (CE). It is the cost of replacing or hedging a contract at the time of default. Other measures include Potential future exposure (PFE), Expected exposure (EE), Expected Positive Exposure (EPE), Effective expected exposure (EEE), Effective EPE, Exposure at default or EAD. This presentation is intended to answer several fundamental questions: what is CCR? How to measure CCR? What are the provisions governing counterparty risk? You can find more information at http://www.finpricing.com/lib/ccr.html

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Counterparty Credit Risk

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  1. Counterparty Credit Risk Alex Yang FinPricing http://www.finpricing.com

  2. CCR Summary ◆ Counterparty Credit Risk Definition ◆ Counterparty Credit Risk Measures ◆ Close Out ◆ Master Agreement ◆ CSA Agreement ◆ Final Credit Exposure

  3. CCR Counterperty Credit Risk (CCR) Definition ◆ Counterparty credit risk refers to the risk that a counterparty to a bilateral financial derivative contract may fail to fulfill its contractual obligation causing financial loss to the non-defaulting party. ◆ Only over-the-counter (OTC) derivatives and financial security transactions (FSTs) (e.g., repos) are subject to counterparty risk. ◆ If one party of a contract defaults, the non-defaulting party will find a similar contract with another counterparty in the market to replace the default one. That is why counterparty credit risk sometimes is referred to as replacement risk. ◆ The replacement cost is the MTM value of a counterparty portfolio at the time of the counterparty default.

  4. CCR Counterperty Credit Risk Measures ◆ Credit exposure (CE) is the cost of replacing or hedging a contract at the time of default. The CE of a typical interest rate swap is shown below 7,000,000.00 6,000,000.00 5,000,000.00 exposure 4,000,000.00 3,000,000.00 2,000,000.00 1,000,000.00 - 0 500 1000 1500 2000 2500 3000 3500 Days

  5. CCR Counterperty Credit Risk Measures (Cont’t) ◆ Potential future exposure (PFE) is the credit exposure at a specified quantile on a future date. ◆ Expected exposure (EE) is the average (expected) credit exposure on a future target date. ◆ Expected positive exposure EPE) is the weighted average of EE. ◆ Effective EE is equal to the maximum of EE before time t. ◆ Effective EPE is the weighted average of Effective EE. ◆ Exposure at default (EAD) = ? * EffectiveEPE, where ? = 1.4.

  6. CCR Close Out ◆ If a contract value > 0 to a bank at the time of default, the bank ◆ closes out the position and receives nothing from the defaulting counterparty; ◆ then enters a similar contract with another party and pays the contract value. ◆ The exposure is the replacement cost, i.e., the contract value ◆ If the contract value < 0 to the bank at the time of default, the bank ◆ closes out the position and pays contract value to the defaulting counterparty ◆ then enters a similar contract with another party and receives the contract value. ◆ The net loss is zero. ◆ Thus the credit exposure can be expressed as E(t) = max(V(t), 0)

  7. CCR Master Agreement ◆ Master agreement is a document agreed between two parties, which applies to all transactions between them. ◆ Close out and netting agreement is part of the Master Agreement. ◆ If two trades can be netted, the credit exposure is ? ? = ??? ?1? + ?2? ,0 ◆ If two trade cannot be netted (called non-netting), the credit exposure is ? ? = ??? ?1? ,0 + ??? ?2? ,0

  8. CCR CSA Agreement ◆ Credit Support Annex (CSA) or Margin Agreement or Collateral Agreement is a legal document that regulates collateral posting. ◆ Trades under a CSA should be also under a netting agreement, but not vice verse. ◆ It defines a variety of terms related to collateral posting: ◆ Threshold ◆ Minimum transfer amount (MTA) ◆ Independent amount (or initial margin or haircut)

  9. CCR CSA Agreement (Cont’d) ◆ The credit exposure of the interest rate swap after taking CSA into account can be illustrated as 2,500,000.00 Exposure 4,000,000.00 3,500,000.00 3,000,000.00 2,000,000.00 1,500,000.00 1,000,000.00 500,000.00 - 0 500 1000 1500 2000 2500 3000 3500 Days

  10. CCR Final Credit Exposure ◆ After taking master agreement and collateral posting into account, the final counterparty credit exposure equals ?????? = ????+ ???+ ???? ? ? ? where ????– the exposure for a trade with both CSA and netting agreement; ????– the exposure for a trade with netting agreement but without CSA; ????– the exposure for a non-netting trade.

  11. Thanks! You can find more details at http://www.finpricing.com/lib/ccr.pdf

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