Background

• Counterparty credit risk (often known just as counterparty risk) is the risk that the entity with
  whom one has entered into a financial contract (the counterparty to the contract) will fail to
  fulfil their side of the contractual agreement (for example, if they default).

Counterparty Risk Versus Lending Risk

• In lending risk, one party owes an amount to another party and may fail to pay some or all of
  this due to insolvency. This can apply to loans, bonds, mortgages, credit cards and so on.
• Two main features are –
  • The notional amount at risk at any time during the lending period is usually known with a
    degree of certainty.
  • Only one party takes lending risk.
• Counterparty risk arises when the entity with whom one has entered into a financial contract (the counterparty to the contract) fails to fulfil their side of the contractual agreement (for example, if they default).
• Counterparty risk, is different from traditional credit risk on the two aspects –
  • The value of the contract in the future is uncertain in most cases.
  • Since the value of the contract can be positive or negative, counterparty risk is typically bilateral, i.e., each counterparty in a derivatives transaction has risk to the other.

Settlement And Pre-Settlement Risk

• • Pre-settlement risk is the risk that a counterparty will default before the final settlement (or expiration) of the transaction. This is what counterparty risk usually refers to.
  • Settlement risk arises at settlement times due to timing differences between when each party performs on its obligations under the contract.

• • All derivatives technically have both settlement and pre- settlement risk, and the balance between the two is different depending on the contract.
    • Spot contracts have mainly settlement risk.
    • Long-dated contracts have mainly pre-settlement (counterparty) risk.
  • Unlike counterparty risk, settlement risk involves a very large exposure – potentially, of the notional transaction. Even though settlement risk gives rise to much larger exposures, the probability of default at the settlement date is much lower than the probability of default before expiration of the contract.
  • Settlement risk is a major consideration in markets, where settlement of a contract involves a payment of one currency against receiving the other.
  • Settlement risk typically occurs for only a small amount of time (often just days, or even hours).
  • Recent developments in collateral posting, potentially create more settlement risk, and associated liquidity problems, as parties have to post and receive large cash payment in silos across multi-currency portfolios.

Case Study – Bankhaus Herstatt

A well-known example of settlement risk is the failure of a small German bank, Bankhaus Herstatt. On 26th June 1974, the firm defaulted but only after the close of the German interbank payments system (3:30pm local time). Some of Herstatt Bank’s counterparties had paid Deutschemarks to the bank during the day, believing they would receive US dollars later the same day in New York. However, it was only 10:30am in New York when Herstatt’s banking business was terminated, and consequently all outgoing US dollar payments from Herstatt’s account were suspended, leaving counterparties fully exposed.

Margin Period Of Risk

• Margin Period of Risk (MPoR) is the time period from the last exchange of collateral covering a netting set of transactions with a defaulting counterparty until that counterparty is closed out and the resulting market risk is re-hedged. MPoR basically refers to the risk horizon when collateralized/margined (due to the imperfect nature of this process).
• The standard assumption used for MPoR in collateralized bilateral derivatives is 10 business days, but centrally-cleared OTC derivatives (which are subject to daily margining) have a shorter value of five days.
• This reduces counterparty risk because the MPoR will typically be significantly shorter than the remaining maturity of the portfolio.
• There is an important interaction between settlement risk and the counterparty risk on a collateralized portfolio since each (net) settlement will change the underlying value of the portfolio.
  • If this valuation change is positive, then the portfolio value increases, which will be uncollateralized until collateral can be received. This, therefore, can intuitively create a “collateral spike” for the duration of the MPoR (as shown in this figure)

  

  Illustration of the spike in exposure created by a cash flow payment and subsequent delay before collateral is received (or the derivative is closed out in the event of a default).

Sources Of Counterparty Risks

• Counterparty risk is typically defined as arising from two broad classes of financial products –
  • OTC derivatives (e.g. interest rate swaps) – In this case, the risk is more significant due to size and diversity of the OTC derivatives market and the fact that a significant amount of exposure is not collateralized.
  • Securities financial transactions (e.g. repos) – As an example, the main risk in repo transaction arises on two fronts –
    • The risk that the seller of the securities would not repurchase the securities at the end of
      the tenure.
    • The risk that the value of the securities sold would decrease over the tenure of the loan
      leading to an increased exposure.

Exposure And Product Type

• Most counterparty risk arises from bilateral OTC derivatives. This can be seen when looking at the averaged response from banks on their counterparty risk (measured by credit value adjustment, CVA) broken down by asset class in this figure. This breakdown contains counterparty risk from OTC derivatives that are collateralized (bilaterally, at least).
• This table gives an example of a useful decomposition (of CVA) by rating and sector (i.e.
  counterparty type).
• The counterparty risk faced with high-quality credits is generally small due to the low default probability.
• Financial institutions also represent a relatively small part due to relatively good credit quality and the fact that most of these transactions are probably collateralized.
• The majority of the counterparty risk is faced with respect to medium credit ratings (BBB to A-) and corporates and governments, most of which is likely to be uncollateralized.
• The reasonably small exposure (given their high default probability) to non-investment-grade counterparties is probably due to a partial reluctance to trade with such
  entities.
• For derivatives products, their exposure is quite smaller than that of an equivalent loan or bond. For example, a plain vanilla interest rate swap contract has no principal risk because only cashflows are exchanged. Even the coupons are not fully at risk because only the difference in fixed and floating coupons or net payment is exchanged.
  • Hence, the actual total market of derivatives is much lower than the total notional amount outstanding, as given in this table. For example, the total market value of interest rate contracts is only 3.1% of the total notional outstanding.
  • It is the market value that is more relevant, since this is representative of the loss that is suffered in a default scenario and is the amount that has to be funded or collateralized.

  	Gross National Outstanding	Gross Market Value	Ratio (%)
  Interest Rate	505.5	15.6	3.1%
  Foreign Exchange	75.9	2.9	3.9%
  Credit default Swaps	16.4	0.6	3.6%
  Equity	7.9	0.6	7.8%
  Commodity	1.9	0.3	17.0%

Institutions Taking Counterparty Risk

• Large Derivative Players
  • Organizations – Large banks & Financial Institutions
  • Market Impact – High (Can move the market quickly)
  • Deal Size – Large transactions and contracts
  • Risk Type – Systemic risk
  • Regulatory Oversight – High
• Medium Derivative Players
  • Organizations – Mid-size banks & Financial Institutions
  • Market Impact – Low (No large positions to move the market quickly)
  • Deal Size – Small transactions
  • Risk Type – Low Systemic risk
  • Regulatory Oversight – Medium / High
• Small Derivative Players
  • Organizations – Corporates
  • Market Impact – Low
  • Deal size – Small transactions (Specific for hedging purposes)
  • Risk Type – Low Systemic risk
  • Regulatory Oversight – Medium / High
• Other Institutions
  • Organizations – CCPs, End Users, Third Parties etc.
  • Market Impact – High for CCPs and very low for others
  • Deal Size – Variable
  • Risk Type – High systemic risk for CCPs and low systemic for others
  • Regulatory Oversight – Medium / High / Low

Credit Limits

• • Counterparty risk can be diversified by limiting exposure to any given counterparty, broadly in line with the perceived default probability of that counterparty. This is the basic principle of credit limits (or credit lines).

• Credit limits are generally specified at the counterparty level, as shown in this figure. The PFE represents a worst-case scenario. The idea is to characterize the potential future exposure (PFE) to a counterparty over time and ensure that this does not exceed a certain value (the credit limit).
• The credit limit will be set according to the risk appetite of the party in question. It may be time- dependent.
• Credit limits will often be reduced over time, effectively favoring short-term exposures over long-term ones.
• The credit limit of a counterparty with poor credit quality (sub-investment grade) should increase over time, because if the counterparty does not default then its credit quality will be expected to improve eventually.
• Credit limits should be conditional on non-default before the point in question, because the possibility of an earlier default is captured via a limit at a previous time.
• Limits could be breached for two reasons:
  • either due to new transactions, or
  • market movements.

  The first case is easily dealt with by refusing transactions that would cause a limit breach.
  The second is more problematic, and banks sometimes have concepts of hard and soft limits. Soft limits may be breached through market movements rather than new transactions, whereas a breach of hard limits would require remedial action.

• Credit limits are binary in nature, which is problematic. Sometimes a given limit can be fully utilized, preventing transactions that may be more profitable.

Credit Value Adjustment (CVA)

• Credit valuation adjustment (CVA) is the difference between the risk-free portfolio value and the true portfolio value that takes into account the possibility of a counterparty’s default. In other words, is the market value of counterparty credit risk.
• Since represents the actual price of counterparty risk, it is, therefore, a step forward from credit limits, since, from an approval point of view, the question becomes whether or not it is profitable once the counterparty risk component has been “priced in”.
• Like PFE, is also a counterparty level calculation. should be calculated incrementally by considering the increase (or decrease) in exposure, taking into account netting effects due to any existing trades with the counterparty. Hence, will be additive across different counterparties and does not distinguish between counterparty portfolios that are highly concentrated.
• A counterparty with a large default probability and a small exposure may be considered preferable to one with a larger exposure and smaller underlying default probability – but this is not clear. puts a value on counterparty risk and is one way to distinguish numerically between these two types of counterparties.

CVA and Credit Limits

• There should be three levels to assess the counterparty risk of a transaction –
  • Trade level. Incorporating all characteristics of the trade and associated risk factors. This
    defines the counterparty risk of a trade at a “stand-alone” level.
  • Counterparty level. Incorporating the impact of risk mitigants such as netting and collateral for each counterparty (or netting set) individually. This defines the incremental impact that a trade has with respect to existing transactions.
  • Portfolio level. Consideration of the risk to all counterparties, knowing that only a small fraction may default in a given time period. This defines the impact a trade has on the total counterparty risk faced by an institution.

CVA vs Credit Limits

Risk measurement

• CVA focuses on evaluating counterparty risk at the trade level and counter party level (incorporating risk mitigants)
• In contrast, credit limit its essentially at the portfolio level by limiting exposures to avoid concentrations.

Risk management

• CVA encourages minimizing trading counterparties, since this maximizes the benefits of netting.
• Credit limits encourages to maximize the trading counterparties to encourage smaller exposures and diversification.

Mitigating Counterparty Risk

1. Netting –
   • Netting allows components such as cash flows, values, and margin or collateral payments to
     be offset across a given portfolio.
   • There are a number of forms of netting, such as cash flow netting, close-out netting, and
     multilateral trade compression, which may be applied bilaterally or multilaterally.
   • However, netting also creates legal risk in cases where a netting agreement cannot be legally
     enforced in a particular jurisdiction, exposing creditors to more significant losses.
2. Collateralization –
   • Collateral or margin agreements specify the contractual posting of cash or securities against
     mark-to-market (MTM) losses.
   • There is still a residual market risk since exposure exists in the time taken to receive the
     relevant collateral amount (MPoR)
   • Taking collateral to minimize counterparty risk creates operational risk due to the necessary
     logistics involved, and leads to liquidity risk since the posting of collateral needs to be
     funded, and collateral itself may have price and FX volatility.
   • Taking certain types of collateral – even cash – can create wrong-way risk.
3. Other contractual clauses –
   • Other features, such as resets or additional termination events, aim to periodically reset
     MTM values or terminate transactions early.
   • Like collateral, these can create operational and liquidity risks.
4. Hedging–
   • Hedging counterparty risk with instruments such as credit default swaps (CDSs) aims to
     protect against potential default events and adverse credit spread movements.
   • Hedging creates operational risk and additional market risk through the mark-to-market
     (MTM) volatility of the hedging instruments.
   • Hedging may lead to systemic risk through feedback effects.
5. Central counterparties(CCPs) –
   • CCPs guarantee the performance of transactions cleared through them through the use of
     collateral and other financial resources that they require from their members.
   • CCPs act as intermediaries to centralize counterparty risk between market participants.
   • While offering advantages such as risk reduction and operational efficiencies, they require the centralization of counterparty risk, significant collateralization and mutualization of losses. They can therefore potentially create operational and liquidity risks, and also systemic risk, since the failure of a central counterparty could amount to a significant systemic disturbance.

• Mitigation of counterparty risk is a double-edged sword.
  • On the one hand, it may reduce existing counterparty risks and contribute to improving
    financial market stability.
  • On the other hand, it may lead to a reduction in constraints such as capital requirements and
    credit limits, and therefore lead to a growth in volumes.
• Risk mitigation should really be thought of as risk transfer, since new risks and underlying costs are generated.

Components

• The important components and related metrics that define counterparty risk are –
  1. Valuation and Mark-to-Market
  2. Replacement Cost and Credit Exposure
  3. Default Probability, Credit Migration and Credit Spreads
  4. Recovery and Loss Given Default

Valuation And Mark-To-Market

• A definition of valuation such as Mark-to-market ( ) is the starting point for analysis of counterparty risk and related aspects.
  • Current value does not constitute an immediate liability, but rather is the present value of all the payments that a party is expecting to receive, less those it is obliged to make.
  • The valuation (or MtM) with respect to a particular counterparty defines the net value of all positions (if positive) and is therefore directly related to what could potentially be lost today in the event of a default. This is typically defined as credit exposure.
  • The valuation defines the size of the asset (if positive) or liability (if negative) position and, therefore, is linked to the funding position.
  • In the event that initial margin is posted, this is typically calculated based on the variability of the valuation.
  • Since margin is primarily determined based on the current value, there is clearly a direct link to the cost of collateral.
  • Methodologies for defining capital are always based on the underlying valuation.
• These payments that define the current valuation may be scheduled to occur many years in the future and may have values that are strongly dependent on market variables. The valuation will be positive or negative, depending on the magnitude of remaining payments and current market rates. Hence, all of the above components are relevant from both a current (spot) and future point of view.
• Two questions are important with respect to valuation adjustments –
  1. What is the current valuation? – This is simpler to define.
  2. What is the valuation in the future (since, for example, the counterparty can default at any
     point in the future)? – This is far more complex to answer.
• Valuation adjustments may also depend on risk mitigants.
• There is a potential recursive problem with the above. The valuation is an input parameter for calculating the valuation adjustments, and yet the correct valuation should include valuation adjustments. One solution to this is to consider a base value (without valuation adjustments) and add valuation adjustments linearly as a function of this base value.

Replacement Cost And Credit Exposure

• Default related contractual features of transactions, such as close-out netting and termination features, refer to replacement costs. The base valuation (or MtM) is clearly closely related to replacement cost, but the actual situation is more complicated.
  • To replace a transaction, costs such as bid-offer spreads must be considered, which may be high for illiquid products. Even a standard and liquid contract might become non-standard and illiquid at the default time.
  • Decision whether to replace a transaction with an expensive non-standard derivative or with a more standard one is important.
  • Portfolios can be also be replaced one-for-one or macro-hedged.
  • Replacement costs, by their nature, may include valuation adjustment terms, such as CVA,
    leading to the recursive problem mentioned earlier.
• Credit exposure (also simply known as exposure) defines the maximum loss at a given point in time due to a counterparty defaulting. It is also represents other costs such as capital and funding that appear in other terms.
  • Positive value of a portfolio corresponds to a claim on a defaulted counterparty, whereas in the event of negative value, a party is still obliged to honor their contractual payments (at least to the extent that they exceed those of the defaulted counterparty). This means that if a party is owed money and their counterparty defaults then they will incur a loss, while in the reverse situation they cannot gain from the default by being somehow released from their liability.
  • Exposure is relevant only if the counterparty defaults and hence its quantification is conditional on counterparty default. For simplicity, exposure will be considered independently of any default event and thus, no “wrong-way risk” will be assumed implicitly. Such an assumption is reasonable for most products subject to counterparty risk, even though the idea of conditional exposure should always be kept in mind.
  • Credit exposure is specific to default (and therefore CVA), and other points of view (most obviously funding-related) need not be conditional on counterparty default.
  • Exposure is clearly a very time-sensitive measure, since a counterparty can default at any time in the future and one must consider the impact of such an event many years from now.
  • All exposure calculations, by convention, will ignore any recovery value in the event of a default. Hence, the exposure is the loss, as defined by the value or replacement cost that would be incurred, assuming no recovery value.

Default Probability, Credit Migration And Credit Spread

• When assessing counterparty risk, the credit quality of a counterparty over the entire lifetime of the relevant transactions should be considered. Such time horizons can be extremely long. Ultimately, there are two aspects to consider:
  1. What is the probability of the counterparty defaulting over a certain time horizon ?
  2. What is the probability of the counterparty suffering a decline in credit quality over a
     certain time horizon (for example, a ratings downgrade and/or credit spread widening)?
• Credit migrations or discrete changes in credit quality (such as those due to ratings changes) influence the term structure of default probability. They may cause issues even when a counterparty is not yet in default. There are three important aspects to consider:
  1. Future default probability will have a tendency to decrease due to the chance that the default may occur before the start of any period. The probability of a counterparty defaulting between 20 and 21 years in the future may be very small – not because they are very creditworthy, but rather because they are unlikely to survive for 20 years!
  2. A counterparty with an expectation of deterioration in credit quality will have an increasing probability of default over time (although at some point the above phenomenon will reverse this).
  3. A counterparty with an expectation of improvement in credit quality will have a decreasing probability of default over time, which will be accelerated by the first point above.
• There is a well-known empirical mean-reversion in credit quality, as evidenced by historical credit ratings changes.
  • This means that good (above-average) credit quality firms tend to deteriorate and vice versa. So a counterparty of good credit quality will tend to have an increasing default probability over time, whereas a poor credit quality counterparty will be more likely to default in the short term and less likely to do so in the longer term.
  • The term structure of default is very important to consider.
• Default probability may be defined as real-world or risk-neutral, which will be discussed in detail in later chapter. Real-world default probability of the counterparty is estimated via historical data. Risk-neutral (or market-implied) probability from market credit spreads. Risk-neutral default probabilities have become virtually mandatory for CVA calculations in recent years due
  to a combination of accounting guidelines, regulatory rules and market practice.

Recovery And Loss Given Default

• • Recovery rate (RR) represents the percentage of the outstanding claim recovered when a counterparty defaults. Loss given default (LGD), in percentage terms is 100% – RR. Default claims can vary significantly, so LGD is therefore highly uncertain. Credit exposure is traditionally measured independently, but LGD is relevant in the quantification of CVA.
  • OTC derivatives, bonds and CDSs generally reference senior unsecured credit risk and may appear to relate to the same LGD. However, there are timing issues –
    • When a bond issuer defaults, is realized immediately, since the bond can be sold in the market.
    • CDS contracts are also settled within days of the defined “credit event” via the auction that likewise defines the LGD.
    • However, OTC derivatives cannot be freely traded or sold, especially when the counterparty to the derivative is in default. This essentially leads to a potentially different LGD for derivatives.

These aspects were very important in the Lehman Brothers bankruptcy of 2008.

• • After the global financial crisis (GFC), the hidden costs of derivatives and counterparty risk led to an increased interest in CVA. In order to understand these aspects, consider the situation represented in this figure, where an uncollateralized derivative is hedged with a collateralized one. When the market moves, funding and capital costs will be incurred to maintain the hedge. In addition to the obvious counterparty risk problems, the following economic aspects are also relevant –
    1. Funding. It will be necessary to post collateral on the hedge and this amount will need to be funded. Furthermore, any initial margin posted will also need to be funded.
    2. Collateral. There will be a choice of the currency of cash and type of securities that can be used to collateralize the negative MtM.
    3. Initial Margin. Some situations, such as central clearing, require the posting of initial margin in order to mitigate counterparty risk. This initial margin represents over-collateralization and represents a funding cost.
    4. Regulatory capital. Banks face regulatory capital requirements for counterparty risk and CVA.

• The xVA concept is used to fully assess the lifetime cost of an OTC derivative, including all as illustrated in this figure. The explanation of the different aspects of the economically relevant terms is as follows –
  1. Positive value.
     • When the portfolio has a positive value and is “in the money” (ITM) (above the center line), then the uncollateralized component gives rise to counterparty risk and funding costs.
     • If some or all of the value is collateralized,
       the counterparty may be able to choose, what
       type of collateral to post (with the range specified contractually).
  2. Negative Value.
     • When the portfolio has a negative value or is “out of the money” (OTM), then there is counterparty risk from the party’s own default and a potential funding benefit to the extent it is uncollateralized. If margin is required, the institution may be able to choose the type of collateral to post.
  3. Overall.
     • Whether or not the transaction has a positive or negative MTM, there are costs from funding the capital that must be held against the transaction and any initial margin that needs to be posted.

Components Of The xVA Term

Illustration of the role of valuation adjustments (xVAs). Note that some xVAs can be benefits

• xVA (or x-Value Adjustment) is like an umbrella term that refers to the different types of valuation adjustments relating to derivative contracts which consider the existence of funding costs, counterparty credit risk, and regulatory capital costs. An xVA term quantifies the cost (or benefit) of a component such as counterparty risk, collateral, funding, or capital over the lifetime of a given transaction or portfolio. Banks incorporate xVAs into the price of a new trade.
• Valuation may start from a base case which may only be relevant in certain specific cases. After this, there are a variety of terms defined as follows –
  1. CVA and DVA. Defines the bilateral valuation of counterparty risk. DVA (debt value adjustment) represents counterparty risk from the point of view of a party’s own default.
  2. FVA. Defines the cost and benefit arising from the funding of the transaction. It is divided into two terms: funding cost adjustment (FCA) and funding benefit adjustment (FBA).
  3. ColVA. Defines the costs and benefits from embedded optionality in the collateral agreement (such as being able to choose the currency or type of collateral to post), and any other non-standard collateral terms (compared to the idealized starting point).
  4. KVA. Defines the cost of holding capital (typically regulatory) over the lifetime of the transaction.
  5. MVA. Defines the cost of posting initial margin over the lifetime of the transaction.
• It is also important to note that there are potential overlaps between the above terms – such as those between DVA and FVA, where own default risk is widely seen as a funding benefit.

Components Of xVA

• • Counterparty risk represents a combination of
    • Market risk, which defines the exposure, and
    • Credit risk that defines the counterparty credit quality.

More generally, any valuation adjustment term is made up of a market component (directly or indirectly related to the base portfolio value) and a cost (or benefit) component (defining the cost of bearing the market component). This is outlined in this table.

Counterparty Risk	Valuation Adjustment Term	Market Component	Cost Component
Counterparty Risk	CVA/DVA	Credit exposure	Default probability
Funding	FVA MVA	Valuation Initial margin amount	Funding cost
Collateral	ColVA	Collateral amount	Collateral cost
Capital	KVA	Capital amount	Capital cost