Counterparty Credit Risk (CCR)

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Counterparty Credit Risk (CCR)

Definition
Credit risk arising from two classes of financial products:
OTC derivatives, most important source of CCR
Securities Financing Transactions (SFTs)
i.e. repos, securities lending and borrowing, margin lending
Unlike classical credit risk arising from lending activities,
The value of the contract in the future is highly uncertain
Since the value can be positive or negative, counterparty risk is bilateral

PD X LGD X EAD = Expected loss

EAD for derivatives is contingent on the market scenarios that will affect their
value over their lifetime.

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Example of Counterparty Credit Risk

IRS between Bank A and Bank B

Floating liability payments

Pay Floating
Bank A

Bank B

Lays off exposure to

the market

Pays Fixed rate

Market value at inception is 0 to both counterparties (no arbitrage).

As soon as interest rates deviate from initial expectations, the trade will

become more valuable to one counterparty.

The replacement cost at that point will be positive to one counterparty and

negative to the other.

The counterparty to whom the trade is more valuable hence has an

exposure.

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Counterparty Credit Risk exposure

For OTC derivatives:

Mark-to-Market

Counterparty Credit Risk for the firm

In the money

Life of contract

Out of the money

Counterparty Credit Risk for the

counterparty

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Counterparty risk v. Market risk

Trades which offset market risk do not generally offset counterparty

risk.

fixed interest

UBS

fixed interest
DB

floating interest

BAML

floating interest

No P&L exposure thus no market risk

But Counterparty Credit Risk

UBS Trade
Net

BAML Trade

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Key terms

MtM

Adjustment made to the risk free value of derivative assets to reflect the default risk of the counterparty
Takes into account that in the event of counterparty default the firm will not realize the future value of the transaction.

Debit valuation adjustment (DVA) Adjustment made to derivative liabilities to reflect the default risk of the bank

This is the Probability of Default , the likelihood that a counterparty will default
2 forms: market implied and real world (often called historical PDs)

CVA

Mark-to-Market, current (default) risk free value of an OTC derivative, can be positive or negative for the firm
Related to replacement cost in case of counterparty default (exposure measurement)

DVA

PD

LGD

EAD

The loss that the firm would incur in the event of the counterparty default
This is the Loss Given Default
The exposure that the firm would have at default this is the current exposure plus any likely drawdown/increase in
lines that could occur before default, or changes in the exposure of derivatives or repo transactions, taking collateral
into account

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Why quantify Counterparty Credit Risk?

Pricing

Managing &
Hedging

Accounting Rules

Capital
Requirements

Incorporation in the prices of derivatives for corporate clients

Assessing prices in the wholesale market

Limit exposures and concentrations

Reducing the exposure to CCR in an economic sense?
Reducing (IFRS, fair value) P&L volatility?
Reducing regulatory capital charge?
Monetizing your own credit risk?

IFRS 13: Issued in May 2011, applicable from 1 January 2013

Convergence with US GAAP (SFAS 157/ASC 820) on the definition of fair value
Fair value of financial liability includes non-performance risk
DVA expected to become industry standard, though uptake seems slow currently

Basel II: Capital charge for default risk of the counterparty

Basel III
Stressed conditions for the default charge of Basel II
Introduction of a capital charge for CVA volatility
Internal Capital Requirement assessment: ICAAP, Economic Capital

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Mitigating Counterparty Credit Risk

Firms have been using a number of approaches to reduce the risk associated
with counterparty credit exposures:
Diversification

Netting Agreement

Spread exposure
across different
counterparties,
especially high
quality

Single legal
exposure allowing
the aggregation of
transactions with a
given counterparty

Margin &
Collateralisation

Hedging with
credit protection

Central
Counterparties

Transfer of
collateral (cash,
securities) when the
transactions market
value exceeds a
specified threshold

Buying CDS
protection with the
reference entity
being the
counterparty and a
notional equal to
credit exposure

Clearing Houses
reduce risk through
mutualisation of risk
and high levels of
collateral
maintained on a
daily basis

Other methods, such as quarterly reset clauses and break clauses are built
into contracts
Credit risk
mitigants are beneficial
but createCentral
other types of risk
Netting
Collateralisation
Counterparties

Operational
risk

Liquidity
risk

Systemic
risk

Collateral and margining

Some issues:
Financial collateral is used to
reduce the positive exposure
Parties typically have to post:
Initial margin
Variation margin

Credit support annex (CSA)

defined terms

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One way or two way

Acceptable collateral (eg.
cash, government securities
etc.)
Haircuts
Frequency
Threshold Amount
(unsecured amount)
Minimum Transfer Amount
(no smaller collateral
transfer)
Independent Amount (given
upfront)

Collateral disputes
Operational / settlement
failures

Margin period of risk: period over

which additional collateral may not
be forthcoming
Measures the time between
last received margin call and
closeout /
re-hedge in a worst-case
scenario
Collateral haircuts are meant
to reflect the potential
variation in the value of the
collateral over that period

CVA and DVA

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What is CVA/DVA?
Recently introduced in financial accounts

Credit Value Adjustment (CVA) is the market value of the risk component
correcting for the Counterparty Credit Risk (CCR) in the value of the derivative
Debit Value Adjustment (DVA) is the market value of the risk component
correcting for the own credit risk in the value of the derivative

CVA was a major driver of balance sheet volatility during the crisis

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Bilateral nature of CCR

CVA
and
DVA
on
the
same
A simple reminder
transaction
You enter into an interest rate swap, uncollateralised, at
Value < 0
Fair Value > 0
zero cost. Fair
(your perspective)
(your perspective)
ApartDefaults
from market
risk,
i.e.,
the interest
Counterparty
Counterpartys
liquidator
has amovements
Your claim goesof
into the
on you in the bankruptcy
liquidation procedures, leading
rate, you areclaim
also
exposed to counterparty
default
risk.
procedures
you to recover some of
the
fair value (LGD!)
CVA
Your counterparty is exposed to positive
your
default.
You have to look for an

alternative hedge, possibly at

the original (now off-market)
conditions. Option structure!
You default

The counterparty has a claim on

you in the liquidation procedures,
but it is likely not to recover the
full fair value. Your liability is in
fact diminished.

DVA

Your liquidator has a claim on the

counterparty in the bankruptcy
procedures.

Still exposed to
default risk

Contingent Bilateral Credit Value

Adjustment: CVA and DVA
Bilateral CVA
DVA

The Bilateral Credit Value Adjustment (BCVA) is an

The Debit Value Adjustment (DVA) is made to

extension of the CVA. To calculate the CVA we only
compensate for the default of the bank itself.
considered the default of the counterparty. To calculate
A decrease in the credit-worthiness of the bank leads
the BCVA we also consider the default of the bank.
to an increase of the mark-to-market of the portfolio
causing a profit.
Calculations of the BCVA

BCVA = DVA CVA.

The first step to calculate BCVA is the time and order of the banks and
counterpartys default, possibly in a correlated way.

Time of
default leads
to

B and C
default after
maturity

C defaults
before B
and
maturity

B defaults
before C
and
maturity

First to default: six possible scenarios which depend on the default time of
the Bank (B) and the Counterparty (C).

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Scenario 1

Default B

Default C

Maturity
Time

Scenario 2
Scenario 3

Default B
Default C

Default C
Default B

Maturity
Time

CVA

Time

No impact

Scenario 4
Default C
Scenario 5
Scenario 6

Maturity

DVA

Default B
Default B

Default C

Default C

Default B

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CVA components
CVA is the incorporation of the cost of the counterparty credit exposure in the
value of an OTC derivative, i.e. cost of a potential credit loss arising from
future counterparty default

The risk of credit loss arising from future counterparty default is driven
by market risk factors and
by the PD and LGD of the counterparty, and
by credit risk mitigation (netting, cash margining and collateral)
Potential future credit loss = (future MtM future collateral) - recovery
Future positive MtMs only are considered in the context of CVA
In the absence of dependence between the credit worthiness of the
counterparty and the exposure, the CVA can be written as :

EE is average over a
given time bucket of the
(netted) MtM, if positive

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DVA Definition
Debit Value Adjustment is the adjustment made to derivative liabilities to
reflect the default risk of the bank and the market value of non-performance
risk
Debit Value Adjustment (DVA)
In theory, mirror image of CVA
The exposure component of the credit risk equation is subject to changes
depending on movements in market risk factors
A decrease in the credit-worthiness of the bank leads to an increase of the
mark-to-market of the portfolio causing a profit.

DVA Own PD X own LGD X Expected Negative Exposure

Own spread x Negative EAD

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A generic CVA/DVA calculation flow

Data

Position
Reference

Position Re-Valuation
Exposure Calculation
(EAD/EPE/PFE/etc.)
Pricing Models

Market
Approximate
Pricing Models

Netting & Collateral

Information

Bilateral default
WWR calculator
CVA/DVA
Data

Risk Factor
Simulation

(Default)
dependency

Data

CDS prices

CDS Data
Bootstrapping
PD/LGD profiles

Benchmarks
LGD Info
Obligor mapping