Counterparty credit risk. general review


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Counterparty credit risk. general review

  1. 1. Counterparty credit risk Roman Kornyliuk, Ph.D. in Finance December 2012
  2. 2. Content• Counterparty credit risk (CCR) definition• CCR management tools• CCR indicators• CCR and Basel II• CCR and Basel III
  4. 4. CCR definition• Counterparty credit risk – the risk that the counterparty to a financial contract will default prior to the expiration of the contract and will not make all the payments required by the contract.• Only the contracts privately negotiated between counterparties - over-the-counter (OTC) derivatives and security financing transactions (SFT) – are subject to counterparty risk.• Exchange-traded derivatives are not affected by CCR because of the exchange guaranties
  5. 5. CCR specific nature: There are two features that set CCR apart from more traditional forms of credit risk:• the uncertainty of exposure since the contract value changes unpredictably over time as the market moves, only the current exposure is known with certainty, while future exposure is uncertain.• the bilateral nature of credit risk since either counterparty can default, counterparty risk is bilateral.
  7. 7. CCRM mitigation toolsCounterparty credit exposure can be reduced by:• Trading with high-quality counterparties• Diversification. Spreading exposure across different counterparties.• Netting. Being legally able to offset positive and negative contract values with the same counterparty in the event of their default.• Collateralisation. Holding cash or securities against an exposure.• Hedging. Trading instruments such as credit derivatives to reduce exposure and counterparty risk.
  8. 8. CCRM mitigation toolsOther forms of traditional counterparty credit risk management (CCRM) include:• the development of a broad set of risk metrics,• ongoing monitoring and evaluation of exposures such as: - stress testing on a consolidated basis over a range of suitably stressful scenarios; - due diligence to understand the strategies and history of the counterparty; - limits on specific trades, exposures, or concentrations; - well-defined processing arrangements and settlement protocols.
  10. 10. CCR indicators:Exposures: CE, PFE, EE, EPE, Effective EE and EPECredit risk indicators: EAD, PD, LGD, Recovery rateCredit Valuation Adjustment (CVA)
  11. 11. CE, PFECE (Current Exposure)- the larger of zero market value of a transaction or portfolio of transactions within a netting set with a counterparty that would be lost upon the default of the counterparty, assuming no recovery on the value of those transactions in bankruptcy.- Current exposure is also called Replacement Cost.PFE (Potential Future Exposure)- the maximum positive exposure estimated to occur on a future date at a high level of statistical confidence.Used in: measuring CCR exposure against counterparty credit limits.
  12. 12. CE,PFE
  13. 13. EE, Effective EEEE (Expected Exposure)- the probability-weighted average exposure estimated to exist on a future date.EEE (Effective Expected Exposure) at a specific date- the maximum expected exposure that occurs at that date or any prior date. Simply, non-decreasing EE. We need EEE because EE not capture properly rollover riskUsed in: calculating the economic capital
  14. 14. EE EE, Effective EE - Only the positive exposures on the given date are averaged -The average of the negative exposures is the expected exposure of the other counterparty to the contract.
  15. 15. EE EE vs. PFE - EE will be greater than the expected MtM since it concerns only the positive MtM values
  16. 16. EE EE and Effective EE Effective EE is non-decreasing EE
  17. 17. EPE, Effective EPEEPE (Expected Positive Exposure )- the time-weighted average of individual expected exposures estimated for given forecasting horizons (e.g. one year)Effective EPE (Effective Expected Positive Exposure)- the average of the effective EE over one year or until the maturity of the longest-maturity contract in the netting set whichever is smaller.Used in: calculating the economic capital
  18. 18. EPE, Effective EPE
  19. 19. EADIn the calculation of economic capital for CCR under Basel II three main risk parameters are used:- Exposure at Default,- Loss Given Default,- Probability of DefaultEAD (Exposure at Default)- is the expected total amount in currency of the firms counterparty credit exposure in the event the counterparty defaults.- It is often measured for a one year period or over the period until maturity if this is less than one year. CCR generally refers to the bilateral credit risk of transactions with uncertain exposures that can vary over time with the movement of underlying market factors.- Basel II provides three alternative methods for calculating EAD. However, EPE is generally regarded as the appropriate EAD measure to determine the EC for CCR.
  20. 20. LGDLGD (Loss Given Default)- is the loss a firm suffers as a result of the counterparty to an OTC derivative contract defaulting. It is therefore the fraction of EAD that will not be recovered following a default.- Most banks calculate the LGD for an entire portfolio based on cumulative losses and exposure.- A term usually used in the modeling of credit default swaps is recovery rate of default. It is one minus LGD.- LGD is assumed to stay constant over time in some industry sectors. However, LGD is in practice stochastic and is subject to both idiosyncratic (firm specific) and systematic risks .
  21. 21. PDPD (Probability of Default)- The probability of default gives the likelihood that a counterparty to the OTC derivative contract defaults.- It is estimated for a single contract or a portfolio of OTC transactions depending on the credit quality (rating) of the counterparty. Unlike LGD, it doesnt depend on the transaction characteristics of the contract (example, collateral).- Basel II requires that the PD be calculated over a one year horizon. PD of a counterparty may vary with macroeconomic conditions or the business cycle, also it’s depend on credit rating of the counterparty.
  22. 22. CVACVA (Credit Valuation Adjustment)• CVA — the monetized value of counterparty credit risk for a portfolio of over the counter (OTC) derivatives• CVA is the market value of counterparty credit risk: the difference between the risk-free portfolio value and the true portfolio value that takes into account the counterparty’s default.• Therefore CVA is need to calculate the fair value of derivative position
  23. 23. CVA• For years, the standard practice in the industry was to mark derivatives portfolios to market without taking the CCR into account. All cash flows were discounted by the LIBOR curve, and the resulting values were often referred to as risk-free values.• However, the true portfolio value must incorporate the possibility of losses due to counterparty default.• The credit valuation adjustment (CVA) has become an integral part of accounting rules and Basel III.• Roughly two-thirds of CCR losses [credit crisis risk losses] were due to CVA losses and only one-third were due to actual defaults’ (Basel Committee on Banking Supervision).
  24. 24. CVA: unilateral vs. bilateral• CVA can be defined either on a unilateral or a bilateral basis.• Unilateral CVA assumes that the institution which does the CVA analysis (the bank) is default-free. It gives the market value of future losses caused by the counterparty’s potential default.• Bilateral CVA takes into account the possibility of both the counterparty and the bank defaulting. This is required for an objective fair value calculation since both the bank and the counterparty require a premium for the credit risk they are bearing.• Unilateral CVA is now part of Basel III, while bilateral CVA is more in line with the market practice at top financial institutions for pricing and hedging, as well as accounting rules.
  25. 25. BASEL II
  26. 26. CCR and Basel IIMinimum Capital Requirements for Counterparty Credit Risk (1)IRB Approach: Regulatory Capital ( C ) is calculated according to:whereK(PD,LGD) is default-only capital factor that is calculated from PD &LGD according to:MA(PD,M) is maturity adjustment:
  27. 27. CCR and Basel IIThe major difficulty in applying rules to counterparty risk in SFT and OTC derivatives is:• the uncertainty of future exposure• and complexity associated with calculation of future exposure distribution.Basel Committee describes methods of calculating EAD For OTC derivatives, these methods include:- Current Exposure Approach,- Standardized Approach,- Internal Rating-Based Approach (IRBA)in the order of increasing sophistication
  28. 28. CCR and Basel II1. Current Exposure Approach: EAD = RC + Add-onwhereRC - the current replacement cost;Add-on - the estimated amount of the potential future exposure (PFE);For a portfolio of transactions covered under a legally enforceable bilateral netting agreement,RC - simply the net replacement cost across derivative contracts in the netting set, given by the larger of net portfolio value or zero.Add-on - is calculated under the Basel I formula:whereAdd-oni - the Add-on for transaction iNGR - the ratio of the current net replacement cost (RC under full netting) to the current gross replacement cost (RC under no netting) for all transactions within the netting set.
  29. 29. CCR and Basel II2. Standardized Approach:• The standardized method in Basel II was designed for those banks that do not qualify to model counterparty exposure internally but would like to adopt a more risk-sensitive approach than the CEM.where NCV - the current market value of transactions in the portfolio net the current market value of collateral assigned to the netting set; NRPj - the absolute value of net risk position in the hedging set j; CCFj - the credit conversion factor with respect to the hedging set j, that converts the net risk position in the hedging set into a PFE measure.
  30. 30. CCR and Basel II3. Internal Rating-Based Approach• the most risk-sensitive approach for the exposure at default (EAD) calculation available under the Basel II framework. EAD = α × Effective_EPEwhere Effective EPE - the Effective Expected Positive Exposure calculated for each netting set from the expected exposure (EE) profile, α - a multiplier.
  31. 31. CCR and Basel IICalculating EPE Typically, banks that model exposure internally compute exposure distributions at a set of future dates {t1, t2 … tK } using Monte Carlo simulations. For each simulation date t, the bank computes expectation of exposure EEK as a simple average of all Monte Carlo realizations of exposure for that date. EPE is defined as the average of the EE profile over the first year. Practically, it is computed as the weighted average of EEK.
  32. 32. CCR and Basel IIThere are three main components in calculating the distribution of netting-set-level or counterparty-level credit exposure:• Scenario generation: Future market scenarios are usually simulated for a fixed set of simulation dates using evolution models of the risk factors.• Instrument valuation: For each simulation date and for each realization of the underlying market risk factors, instrument valuation is performed.• Aggregation: For each simulation date and for each realization of the underlying market risk factors, instrument values are added within each netting set to obtain netting set portfolio value.
  33. 33. Scenario generation process
  34. 34. BASEL III
  35. 35. Basel III requirements• CVA Capital Charge• Stressed EEPE Reports• Measure Wrong Way Risk• Independent Review of CCR• Counterparty Risk Factors• Stressed PDs• Collateral Reporting
  36. 36. CCR and Basel III• Basel II : counterparty credit risk was capitalized for default risk only. Mark-to-market losses due to CVA were not directly capitalized.• Basel III: the CVA risk capital charge was added WHY? During the financial crisis roughly two-thirds of losses attributed to counterparty credit risk were due to CVA losses and only about one-third were due to actual defaults.
  37. 37. CCR and Basel III• The credit valuation adjustment (CVA) has become an integral part of accounting rules and Basel III.• The Basel III Accord introduced a new capital charge for CVA risk, in addition to the capital charge for counterparty default risk in Basel II.
  38. 38. CVA capital charge (Basel III)internal models method:The CVA capital charge is given by:where:K - the regulatory multiplier (typically set to 3),deltaCVA = CVAd - CVA0 ,CVAd - the CVA d days in the future (d = 10).SVaR denotes the stressed VaR calculated with stressed exposures and spreadscenarios coming from a crisis period.
  39. 39. CVA (Basel III)internal models method:The CVA is given by:where:LGDMKT - the loss given default for the counterparty (1 – recovery),EEi - the expected (unconditional) exposures at each time,Si - the counterparty’s spread.
  41. 41. Market failures limit CCRMTo assess the question of why CCRM might prove insufficient, it is useful to examine potential market failures (in a sense of deviations from a perfectly competitive, full-information economy that efficiently allocates resources) in the provision of credit.These market failures include• agency problems,• externalities,• free-rider problems,• moral hazard,• and coordination failures.
  42. 42. >>> agency problem• An agency problem exists when participants have different incentives, and information problems prevent one party (the principal) from perfectly observing and controlling the actions of the second (the agent).
  43. 43. >>> externality• An externality is an impact of one party’s action on others who are not directly involved in the transaction. If the potential exposure amounts to a significant share of bank capital, then a large shock to hedge funds could weaken banks and impair their ability to provide liquidity to the financial system or credit to borrowers.
  44. 44. >>> competition• The apparent profits to be earned in this business may create competitive pressures that weaken credit risk mitigation practices.• Bernanke (2006), for example, discuss how competition for new hedge fund business may be eroding CCRM, such as through lower than appropriate fees and spreads, or inadequate risk controls such as lower initial margin levels, collateralization practices, or exposure limits.
  45. 45. >>> moral hazard• Moral hazard refers to changes in behavior in response to redistribution of risk, for example, insurance may induce• risk-taking behavior if the insured does not bear the full consequences of bad outcomes. In financial markets, the• question of moral hazard from conjectural guarantees by the government—the implicit promise to bail out certain bank• creditors—may apply to the largest commercial banks, but it does not apply to hedge funds.
  46. 46. >>> free-rider problem• Consider, for example, a large hedge fund that has exposures with many banks, all of whom benefit from the health of the hedge fund.• While in principle every bank should monitor its exposure and limit excess risk-taking by the hedge fund, each bank also has an incentive to free-ride by reducing its CCRM and enjoying the benefits of the CCRM of the other banks.• This is a classic example of “tragedy of the commons,” where private markets may underprovide the public good and create a rationale for official sector intervention.
  47. 47. References1. Basel III. Counterparty credit risk – FAQ. – BCBS. - November 2011.2. Bekele S. Counterparty credit risk. – 2009.3. Brigo D. Counterparty Risk FAQ. – 2011.4. Gregory J. Counterparty credit risk: The New Challenge for Global Financial Markets. – Wiley. – 2010.5. Kambhu J., Schuermann T., Stiroh K. Hedge Funds, Financial Intermediation, and Systemic Risk // FRBNY Economic Policy Review. - December 2007.6. Pykhtin M, Zhu S. Measuring Counterparty Credit Risk for Trading Products under Basel II. – 2006.