Counterparty Risk (I)

In this article I will present some of the basic concepts used to quantify, manage and mitigate counterparty risk.

If you have interest in these topics, please check my previous articles on the subject:

The Credit Decision?|?Classifications and Key Concepts of Credit Risk (I)?|?Classifications and Key Concepts of Credit Risk (II)?|?Rating Assignment Methodologies (I)?|?Rating Assignment Methodologies (II)?|?Rating Assignment Methodologies (III)?|?Credit Risks and Credit Derivatives | Portfolio Credit Risk Models

Counterparty risk is the risk that a counterparty is unable or unwilling to live up to its contractual obligations.?

Counterparty risk is different than lending risk for two main sets of reasons: 1. the future value of the contract is highly uncertain 2. Counterparty risk is bilateral whereas lending risk is unilateral.?

Securities financing transactions (SFT), such as securities lending and borrowing (SLB), repos and reverse repos carry counterparty risk. Over the counter (OTC) derivatives such as interest rate swaps, foreign exchange forwards, and credit default swaps (CDS) also carry counterparty risk.?

Credit exposure is the loss conditional on the counterparty default. It is a time-sensitive measure as the default can occur at any. Therefore, its quantification must consider current exposure, future exposure and contingent claims.

It is important to note that for derivative contracts where there’s no exchange of principal at the onset, the creditor is only at risk for the replacement cost, the cost of entering an equivalent transaction with another counterparty.?

Also important is the fact that credit exposure refers to the loss defined by the replacement cost that would be incurred, therefore assuming no recovery. The loss given default (LGD) in the context of derivatives is different than for example for a bond, as in the case of the later, the LGD can be quickly determined by the market price while when it comes to OTC derivatives, the LGD cannot be determined immediately given the illiquidity of the instruments, especially when the counterparty is in default.

Mark-to-market (MtM) is the present value of all the payments that a party is expecting to receive, minus those it is obliged to make with respect to a counterpart. MtM can be positive or negative depending on the amounts of future payments and market rates, therefore it relates to the potential loss today in the event of a default but excluding important effects of netting and collateral.

In the simple formulation, we have:

RC = max(MtM-C,0)

RC – Replacement Cost

MtM – Mark-to-market at a netting set level

C - Net collateral held

In a later article I will describe these components in further details, also referring the different regulatory approaches used by the banks.

There are several methods that can be used to manage counterparty risk, including the one already referred in the formula above: collateralization. Collateralization is a contractual obligation for counterparties to post securities or cash against MtM losses. A collateral agreement would reduce the credit exposure by requiring a counterpart to post collateral against a negative MtM. In the most common case, two-way agreements are in place, requiring either of the parties to post collateral against a negative MTM.

Another method to manage counterparty risk is to use netting. The MtM referred in the formula above is at a netting set level, meaning that the cashflows from multiple transactions are offset and combined into a single net amount.?

Finally, banks can also use close-out clauses determining the immediate cancellation of all contracts with a defaulted counterparty. In this case, all the contractual obligations are terminated the positions are combined into a single net cash flow, resulting is an immediate realization of net gains or losses.

To mitigate the counterparty risk, banks can use hedging or use central counterparties (CCP). The CCP act as intermediaries between participants, demanding collateral, and other financial obligation.?

Credit Value Adjustment (CVA) represents the market value of the counterparty credit risk:

Total Value of a Derivative=Risk-free value+Value due to Counterparty Risk (CVA)

Basides CVA, there are also other xVA (X-Value Adjustment), referring to the different types of valuation adjustments relating to derivative contracts, including:

• Debt Value Adjustment (DVA): defines counterparty risk from the party’s point of view.
• Funding Valuation adjustment (FDA): cost/benefit resulting from funding a transaction.
• Margin Valuation Adjustment (MVA): cost of posting margin over the duration of a transaction.
• Collateral Value Adjustment (ColVA): cost/benefit from embedded options in collateral agreements as well as any additional collateral terms.
• Capital Valuation Adjustment (KVA): cost of holding capital over the duration of a transaction.

Source: Jon Gregory, The xVA Challenge: Counterparty Credit Risk, Funding, Collateral, and Capital, 3rd Edition (West Sussex, UK: John Wiley & Sons, 2015).