The current interest in the topic of counterparty credit risk (CCR) and its exposure measurement began with the upcoming of the financial crisis, or to be more precise the bankruptcy of Lehman Brothers. Before then, the default of a counterparty of that size was out of the realm of possibility. The default of a counterparty that formerly was assumed as “too big to fail” prompted the need for a reconsideration of credit risk (Moser 2014, p. 429). Among the scope of topics associated with CCR, the determination of the exposure amount is seemingly trivial, but turns out to be highly complex due to the impact of risk mitigants, and the uncertainty involved.
Canabarro and Duffie define counterparty exposure as the larger of zero and the market value of the portfolio of derivative positions with a counterparty that would be lost if the counterparty defaults and there is zero recovery. If the contract value is positive for the bank at the point of the counterparties’ default, the banks net loss equals the contract’s market value. If the contract value is negative, the bank does not gain anything but has a net loss of zero. From a regulatory point of view the Basel Committee on Banking Supervision (BCBS) aims to identify the exposure at default (EAD) which is up stake in the case of a counterparty’s default, which then has to be backed due to capital requirements.
In this main section of the paper an indepth analysis on the characteristics of credit risk exposure and its quantification will be conducted.
At first, the used metrics will be outlined, their characteristics described, and the risk mitigants netting and collateral considered. Last, it will be analyzed for which application the presented measures are suitable and whether they shall be calculated by riskneutral or historical data.
Inhaltsverzeichnis (Table of Contents)
- Introduction
- Assessment on counterparty credit exposure
- Metrics and characteristics
- Driving factors
- The impact of netting
- The role of collateral
- Measurement objectives and their implications for modeling
- Quantification of credit risk exposure
- Risk management counterparty exposure: Add-on method
- Pricing counterparty exposure: CVA
- Monte Carlo simulation
- Summary
Zielsetzung und Themenschwerpunkte (Objectives and Key Themes)
This paper explores the intricate topic of counterparty credit exposure, a critical concern in the world of finance. It delves into the methods and models used to assess and quantify this exposure, particularly in the context of derivatives trading. The paper aims to provide a comprehensive understanding of the key factors driving counterparty credit exposure, the impact of risk mitigators like netting and collateral, and the implications of these factors for both regulatory and economic perspectives.
- Counterparty credit risk (CCR) and its measurement in derivatives trading
- The impact of netting and collateral on exposure
- Regulatory frameworks for CCR, including Basel II and the Internal Model Method (IMM)
- Economic considerations of CCR exposure modeling, including trade approval, pricing, and hedging
- Various methods for quantifying counterparty credit exposure, including the Add-on method, Credit Value Adjustment (CVA), and Monte Carlo simulation
Zusammenfassung der Kapitel (Chapter Summaries)
- Introduction: This chapter sets the stage by outlining the emergence of counterparty credit risk (CCR) as a significant concern following the Lehman Brothers bankruptcy. It defines counterparty exposure and highlights its relevance from both regulatory and economic perspectives. The chapter also emphasizes the need for accurate measurement and modeling of CCR exposure.
- Assessment on counterparty credit exposure: This chapter delves into the intricacies of assessing counterparty credit exposure. It examines various metrics and characteristics used to measure exposure, including the impact of risk mitigators like netting and collateral. The chapter also explores the driving factors behind exposure and the implications of different measurement objectives for modeling.
- Quantification of credit risk exposure: This chapter focuses on the quantitative methods used to measure counterparty credit exposure. It discusses the Add-on method, a risk management approach, and the Credit Value Adjustment (CVA), a pricing methodology. The chapter also examines the application of Monte Carlo simulation for exposure quantification.
Schlüsselwörter (Keywords)
The primary keywords and focus topics of this paper include counterparty credit risk (CCR), counterparty exposure, netting, collateral, regulatory frameworks (Basel II, IMM), economic considerations, risk management, pricing, hedging, Add-on method, Credit Value Adjustment (CVA), and Monte Carlo simulation.
- Quote paper
- Frederik Wulf (Author), 2015, Counterparty Credit Exposure. An Intuitive Guide to Credit Exposure Measurement, Munich, GRIN Verlag, https://www.grin.com/document/301782
