Counterparty Credit Risk: The new challenge for global financial markets ()

Counterparty Credit Risk: The New Challenge for Global Financial Markets......Page 5
Contents......Page 7
Acknowledgements......Page 19
List of Spreadsheets......Page 20
List of Abbreviations......Page 21
Introduction......Page 23
1.1.1 Market risk......Page 27
1.1.4 Credit risk......Page 28
1.1.6 Disadvantages of value-at-risk......Page 29
1.2.1 Why models?......Page 30
1.2.2 Good model, bad model......Page 31
1.3.2 Market structure......Page 32
1.4.1 Too big to fail......Page 33
1.4.3 Compensation culture......Page 34
1.5.1 What is counterparty risk?......Page 35
1.5.3 Counterparty risk and integration of risk types......Page 36
1.5.4 Counterparty risk and today’s derivatives market......Page 37
2.1.1 Origins of counterparty risk......Page 39
2.1.4 OTC derivatives......Page 40
2.1.5 Counterparty risk......Page 42
2.1.6 Counterparty risk versus lending risk......Page 43
2.1.7 Mitigating counterparty risk......Page 44
2.1.8 Counterparty risk players......Page 45
2.2.1 Credit exposure......Page 46
2.2.2 Default probability and credit migration......Page 47
2.2.4 Mark-to-market......Page 48
2.2.6 Exposure......Page 49
2.2.8 Potential future exposure (PFE)......Page 50
2.3.1 Trading with high-quality counterparties......Page 51
2.3.2 Cross-product netting......Page 52
2.3.4 Collateralisation......Page 53
2.3.5 Walkaway features......Page 54
2.3.8 Exchanges and centralised clearing houses......Page 55
2.4.1 Credit lines......Page 56
2.4.2 Pricing counterparty risk......Page 58
2.4.3 Hedging counterparty risk......Page 59
2.4.4 Capital requirements and counterparty risk......Page 60
2.5.2 Expected exposure......Page 61
2.5.5 Overview of exposure metrics......Page 62
2.5.6 Expected positive exposure......Page 63
2.6 Summary......Page 64
Appendix 2.A Characterising exposure for a normal distribution......Page 65
3.1.1 Two-way or one-way agreements......Page 67
3.2.2 Special purpose vehicles......Page 68
3.2.3 Central counterparties......Page 69
3.3.1 Termination events......Page 70
3.3.3 Walkaway features......Page 71
3.4 Netting and close-out......Page 72
3.4.1 Close-out......Page 73
3.4.3 The need for close-out netting......Page 74
3.4.6 The ISDA Master Agreement......Page 76
3.4.9 Advantages and disadvantages of netting......Page 77
3.4.10 Multilateral netting......Page 79
3.5.1 Negativity of MtM......Page 80
3.5.2 Impact of correlation......Page 81
3.5.3 Negative MtM of a netting set......Page 83
3.5.4 Positive MtM of a netting set......Page 84
3.6 Collateral......Page 85
3.6.1 The basics of collateralisation......Page 86
3.6.3 Setting up a collateral agreement......Page 87
3.6.4 Valuation agent......Page 88
3.6.6 Coverage of collateralisation......Page 89
3.6.7 Disputes and reconciliations......Page 90
3.7.1 Linkage of collateral parameters to credit quality......Page 91
3.7.3 Threshold......Page 92
3.7.4 Independent amount......Page 93
3.7.7 Haircuts......Page 94
3.7.8 Coupons and interest payments......Page 96
3.7.10 Call-and-return example......Page 97
3.8 Is risk mitigation always a good thing?......Page 99
Appendix 3.A EE of independent normal variables......Page 100
4.1 Quantifying credit exposure......Page 103
4.1.1 Mark-to-market + add-ons......Page 104
4.1.2 Semi-analytical methods......Page 105
4.1.3 Monte Carlo simulation......Page 106
4.1.4 Roll-off risk......Page 108
4.2.2 Swaps......Page 110
4.2.4 Options......Page 111
4.2.5 Credit derivatives......Page 112
4.2.7 Exercise dates......Page 115
4.3 Models for credit exposure......Page 116
4.3.2 Risk-neutral or real?......Page 117
4.3.3 Equities......Page 119
4.3.6 Credit spreads......Page 120
4.3.7 Interest rates......Page 121
4.3.8 Advanced models......Page 122
4.3.10 Correlations......Page 123
4.4.1 Modelling netting......Page 124
4.4.3 Examples......Page 125
4.5 Exposure contributions......Page 127
4.5.2 Simple two-trade marginal EE example......Page 128
4.5.3 Marginal EE and correlation......Page 129
4.6 Summary......Page 130
Appendix 4.A Semi-analytical formula for exposure of a forward contract......Page 131
Appendix 4.B Computing marginal EE......Page 132
5.2.1 Remargin period......Page 133
5.2.2 Potential future exposure with collateral......Page 135
5.2.4 Collateral volatility......Page 136
5.2.5 Correlation between collateral and exposure......Page 137
5.3 Modelling collateral......Page 138
5.3.1 Parameters......Page 139
5.4.1 Parameters......Page 140
5.4.2 Scenarios......Page 141
5.4.3 Exposure distributions......Page 142
5.4.4 Simple approximation – idealised case......Page 143
5.4.5 Simple approximation – impact of minimum transfer amount......Page 145
5.4.6 Impact of threshold......Page 146
5.4.7 Simple approximation – impact of threshold......Page 147
5.4.8 Operational cost versus reduction of exposure......Page 148
5.5.1 Operational risk......Page 149
5.5.4 Liquidity and liquidation risk......Page 150
Appendix 5.A Calculation of collateralised PFE (cash collateral)......Page 151
Appendix 5.C Mathematical treatment of a collateralised exposure......Page 152
6.1 Defaults, recovery rates, credit spreads and credit derivatives......Page 155
6.1.2 Recovery rates......Page 156
6.1.3 Credit spreads......Page 158
6.2.1 Market growth and uses......Page 159
6.2.2 Credit default swaps (CDSs)......Page 160
6.2.4 Asset swaps......Page 161
6.2.5 Linkage between bonds, asset swaps and CDS premiums......Page 162
6.2.7 Fixed and digital CDSs and recovery swaps......Page 164
6.3.2 Credit events......Page 165
6.3.3 Settlement of CDS......Page 166
6.3.4 Cheapest-to-deliver option and restructuring......Page 167
6.3.5 Delivery squeeze......Page 169
6.3.6 CDS risks......Page 170
6.3.7 ISDA 2009, Big Bang Protocol, Small Bang Protocol and new trading conventions......Page 172
6.4 Estimating default probability......Page 173
6.4.2 Historical estimation......Page 174
6.4.3 Equity-based approaches......Page 177
6.4.4 Market-implied default probabilities......Page 179
6.5.1 CDS index products......Page 181
6.5.2 Index tranches......Page 182
6.5.3 Super senior risk......Page 185
6.5.4 Collateralised debt obligations......Page 186
6.5.5 CDO investors......Page 187
6.5.7 Summary......Page 188
Appendix 6.B Pricing formulas for CDSs and risky bonds......Page 189
Appendix 6.C Pricing of index tranches......Page 192
7 Pricing Counterparty Credit Risk, I......Page 193
7.1.1 Motivation......Page 194
7.1.3 Credit value adjustment (unilateral)......Page 195
7.1.4 Practical CVA formula (no wrong-way risk)......Page 196
7.1.5 CVA as a spread......Page 197
7.1.7 How to calculate the EE for CVA......Page 200
7.2.1 CVA formula with collateral......Page 201
7.2.2 CVA formula with netting......Page 202
7.2.4 Marginal CVA......Page 204
7.2.5 Exotic products......Page 206
7.3.1 Background......Page 207
7.3.2 Bilateral CVA......Page 208
7.3.3 Example......Page 209
7.3.4 BCVA formula from credit spread......Page 211
7.3.5 BCVA or CVA?......Page 212
7.3.6 BCVA and break clauses......Page 214
7.3.7 BCVA and unwinding trades......Page 215
7.3.8 Walkaway features......Page 216
7.4 Summary......Page 217
Appendix 7.A Deriving the equation for credit value adjustment (CVA)......Page 218
Appendix 7.B Approximation to the CVA formula in the case of no wrong-way risk......Page 220
Appendix 7.D Specific approximations to the CVA formula for individual instruments......Page 221
Appendix 7.F Deriving the equation for bilateral credit value adjustment (BCVA)......Page 223
Appendix 7.G Approximation linking CVA formula to credit spreads for bilateral CVA......Page 225
Appendix 7.H Deriving the equation for BCVA under the assumption of a bilateral walkaway clause......Page 226
8.2 Wrong-way risk......Page 229
8.2.2 Right-way risk......Page 231
8.2.3 Examples of wrong-way risk trades......Page 232
8.2.4 Wrong-way risk and CVA......Page 233
8.3.2 Simple example......Page 234
8.3.3 Forward trade example......Page 235
8.3.5 Comparison of wrong-way risk approaches......Page 238
8.3.6 Risky option position......Page 239
8.3.7 Wrong-way risk and bilateral counterparty risk......Page 242
8.4.1 CDS payoff under counterparty default......Page 243
8.4.2 Quantifying CVA for a CDS......Page 244
8.4.3 Buying CDS protection......Page 245
8.4.4 Selling CDS protection......Page 247
8.5.1 Overview......Page 248
8.5.2 Credit indices......Page 249
8.5.3 Index tranches......Page 250
8.5.4 Super senior tranches......Page 251
8.5.5 Counterparty risk distribution across capital structure......Page 252
8.5.6 Impact of upfront tranche payments......Page 254
8.6.2 TRS transactions......Page 255
8.6.4 Converting counterparty risk to gap risk......Page 256
8.7.1 The leveraged super senior (LSS) trade......Page 258
8.7.2 Monolines......Page 261
8.7.3 Credit derivatives products companies (CDPCs)......Page 262
8.7.4 The value of protection purchased from monolines and CDPCs......Page 263
8.8 Summary......Page 264
Appendix 8.A Computing the EE of a typical forward exposure with correlation to a time of default......Page 265
Appendix 8.C Formula for pricing a CDS contract with counterparty risk......Page 266
Appendix 8.D Pricing of a leveraged super senior tranche......Page 268
9.1 Introduction......Page 269
9.2 Hedging and pricing......Page 270
9.3 Hedging a risky derivative position......Page 271
9.4 Traditional hedging of bonds, loans and repos......Page 272
9.5 Risk-neutral or real parameters?......Page 274
9.5.1 Futures prices and future spot prices......Page 275
9.5.2 Drift......Page 276
9.5.3 Volatility......Page 278
9.6 Components of CVA......Page 279
9.7 Recovery risk......Page 280
9.7.1 Basis risk......Page 281
9.7.3 Recovery swaps......Page 282
9.8.1 Static CDS hedging of exposures......Page 283
9.8.2 Contingent credit default swaps (CCDSs)......Page 284
9.9.1 Credit delta......Page 286
9.9.2 Gamma......Page 287
9.9.3 Jump-to-default risk......Page 288
9.10.1 Hedging spot rates......Page 290
9.10.2 Spot rates and drift......Page 292
9.10.3 Volatility......Page 293
9.11.1 Cross-gamma and wrong-way risk......Page 296
9.11.3 Monolines......Page 297
9.11.4 Hedging bilateral counterparty risk......Page 299
9.11.5 Impact of collateralisation on hedging......Page 301
9.12 Aggregation of sensitivities......Page 303
9.13 Summary......Page 304
Appendix 9.A Example of calculation of CVA Greeks......Page 305
10.1 Introduction......Page 307
10.2.1 Double-default approach......Page 308
10.2.2 Merton-style approach......Page 309
10.2.4 Impact on CCDS......Page 310
10.2.6 Impact of random exposure......Page 312
10.3 Credit portfolio losses......Page 313
10.3.1 Loss distributions and unexpected loss......Page 315
10.3.2 Impact of correlation......Page 316
10.4 The impact of stochastic exposure......Page 317
10.4.1 Impact of random exposure on unexpected loss......Page 318
10.4.2 The alpha factor......Page 319
10.4.3 Example of alpha correction......Page 321
10.5 Special cases of alpha......Page 322
10.5.2 Asymmetric exposure......Page 323
10.5.3 Wrong-way risk......Page 324
10.5.4 What is the correct value of alpha?......Page 326
10.6.2 Modelling credit migrations......Page 327
10.6.3 Marking-to-market loans......Page 328
10.6.5 Example......Page 329
10.7 Summary......Page 330
Appendix 10.A Credit portfolio model......Page 331
Appendix 10.B Simple treatment of wrong-way risk......Page 333
11.1 Introduction......Page 335
11.2 The birth of Basel II......Page 336
11.3.2 The advanced IRB approach......Page 337
11.3.3 Asset correlation......Page 338
11.4 Exposure at default and Basel II......Page 339
11.4.1 Current exposure method......Page 340
11.4.2 Standardised method......Page 341
11.4.3 Treatment of repo-style transactions......Page 342
11.5.2 Effective maturity......Page 345
11.5.3 Exposure at default......Page 346
11.5.4 Defining alpha......Page 347
11.5.5 Effective EPE for collateralised counterparties......Page 348
11.6.1 Background......Page 349
11.6.3 Double-default adjustment factor......Page 350
11.6.4 Accounting for double-default for derivatives......Page 352
11.7 Summary......Page 353
Appendix 11.A Effective remaining maturity......Page 354
Appendix 11.C Netting and collateral treatment under the current exposure method (CEM) of Basel II......Page 355
Appendix 11.D Definition of effective EPE......Page 356
Appendix 11.E Double-default treatment of hedged exposures in Basel II......Page 357
12.2.1 Components......Page 359
12.2.3 Responsibilities......Page 361
12.2.5 Mechanics of pricing......Page 362
12.2.7 Technology aspects......Page 363
12.3.1 Background......Page 365
12.3.2 Insurance approach......Page 366
12.3.3 Trading desk approach......Page 368
12.4.1 Real or risk-neutral?......Page 369
12.4.3 Drift, volatility and correlations......Page 370
12.5 How to charge for counterparty risk......Page 371
12.5.3 Pricing incorporating risk mitigants......Page 372
12.5.4 Allocation of CVA......Page 373
12.6 Summary......Page 375
13.1 The triple-A counterparty......Page 377
13.1.2 Derivatives product companies......Page 378
13.1.3 Monolines......Page 379
13.1.4 Credit derivatives products companies......Page 381
13.2.2 Rating agencies and triple-A entities......Page 382
13.2.3 Credit insurer simple example......Page 383
13.2.4 Suspension modes, downgrades and death spirals......Page 386
13.2.5 Termination mode and run-off......Page 387
13.2.6 The random leverage effect......Page 389
13.2.7 The future for credit insurers......Page 390
Appendix 13.B The valuation of credit insurer purchased protection......Page 391
14.1.1 Background......Page 395
14.1.2 Systemic risk in the derivatives markets......Page 396
14.1.3 Historical background to CCPs......Page 397
14.1.4 Bilateral netting versus centralised clearing......Page 398
14.1.5 Novation......Page 399
14.1.7 Impact of default of a CCP member......Page 400
14.1.8 Initial margin......Page 401
14.2 The viability of centralised clearing......Page 403
14.2.1 The advantage of centralised clearing......Page 404
14.2.3 Risk homogeneity and asymmetric information......Page 405
14.2.4 Competition......Page 406
14.2.5 Market coverage of a CCP......Page 407
14.2.6 Central counterparties and credit derivatives......Page 410
14.2.7 Under what circumstances will a CCP work?......Page 411
14.3 Conclusions......Page 412
15.1 A counterparty risk revolution?......Page 415
15.3 Collateral management......Page 416
15.5 Credit value adjustment (CVA)......Page 417
15.8 Central counterparties......Page 418
15.9 The overall challenge......Page 419
Glossary......Page 421
References......Page 431
Index......Page 437