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Optimising Capital Requirements for Counterparty Credit Risk Managing Counterparty Credit Risk

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In this article, Dr. Dmitry Pugachevsky, Director of Research, Quantifi & Rohan Douglas, CEO, Quantifi and Jean-Roch Sibille, Manager, Risk Dynamics & Aurelie Civilio, Senior Consultant, Risk Dynamics discuss the conditions for the effective risk management of Counterparty Credit Risk (CCR) by detailing and comparing capital requirements, identifying inconsistencies in prudential regulations and applying the various capital approaches on some typical portfolio strategies observed within financial institutions.

There is a strong market focus on counterparty credit risk, in particular Credit Value Adjustment (CVA). The attention is predominantly towards the issue of efficient CVA pricing as opposed to implications in terms of risk management and capital requirements. However, since the recent crisis, another issue has gained prominence; the significant losses that counterparty credit risk can cause if not correctly managed.

Portfolio strategies for counterparty credit risk management can vary substantially depending on the institution’s business models. To capture these variations, we calculate CVA for three different portfolios, with different collateral management strategies, and counterparty profiles. The results and analysis can be found in this article.

CCR started essentially as a valuation issue. Slowly, market practice and standardised tools have emerged, including the use of CVA desks. However, during the recent crisis, another issue came to prominence, the significant losses that CCR can cause if not managed properly. In response to this pressing matter, regulators have developed many different approaches to measure this new type of risk, including both standard default risk and market risk - leading to various types of capital requirements.

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