Counterparty Credit Risk is the risk that a party, usually to an OTC derivative contract, may fail to fulfill its obligations, causing replacement losses to the other party. This is similar to the standard definition of credit risk in the sense that the economic loss is due to the default of the obligor. However, it differentiates itself because of the uncertainty around the exposure at default. More specifically, the amount of exposure is uncertain due to the random nature of the contract’s pay-offs.
Why measure Counterparty Credit Risk?
Counterparty credit risk (CCR) is currently one of the most complex topics for financial institutions. This complexity comes from many different sources but is primarily related to the multiple definitions and uses of counterparty credit risk. Therefore, the first question to ask yourself before modeling counterparty credit risk is why do you want to measure it?
You want to determine the market value of your counterparty risk, which corresponds to the difference between the risk-free price of your exposure and the price including the credit risk of your counterparty. This is typically referred to as the Credit Value Adjustment (CVA) and can be considered as an exotic credit option. This computation is rather complex and has to integrate many features, such as
- Expected Exposure
- Credit Risk Parameters
- Bilateral CVA
- Netting Agreements
- Credit Support Annexes (CSA)
- Funding Value Adjustment (FVA)
- Incremental CVA
You want to integrate counterparty credit risk estimates in your profit and loss account, according to accounting standards applicable to your institution. Under International Accounting Standard (IAS 39), banks are required to account for the fair value of OTC derivatives trades, which includes the recognition of fair-value adjustments due to counterparty risk. In addition, it will be required by IFRS 13, as of 1st January 2013, to record DVA for fair value measurement.
You want to know the cost of capital for bearing counterparty credit risk. In order to compute this amount, you should refer to the Basel requirements. This regulation differentiates between two types of counterparty credit risk capital charges: one for the default risk and one for the market risk (usually referred to as CVA capital charge).
The default charge was first proposed by Basel II. However, due to the major losses during the financial crisis, related to the creditworthiness of derivative counterparties, Basel III has introduced the market capital charge. Each of these capital requirements proposes different solutions, with increasing level of complexity.
You want a global and integrated view of the risks your institution is facing regarding counterparty credit risk. For this reason, it is necessary to go beyond the regulatory requirements. Indeed, the objective of the capital requirements is to ensure that institutions can withstand major shocks in counterparty credit risk. However, these regulatory models are developed on a “fit-for-all” basis and only focus on solvency: they do not provide sufficient information for proper risk management such as
- Economic Capital Models for counterparty credit risk
- Stress Testing Scenarios
- Model Risk
- Active Management
What are the key challenges of modeling Counterparty Credit Risk?
Defining the motivations for measuring counterparty credit risk is an important step towards under-standing its complexity. However, in order to achieve a successful implementation, many challenges need to be addressed. Below are some of the potential issues of modelling counterparty credit risk are
- CVA Management
After the 2007 crisis, counterparty credit risk was identified as one of the major causes of turmoil in the financial market, and mostly materialised through downgrades and loss in value, more so than actual defaults. Counterparty credit risk essentially started as a valuation issue, more than ten years ago. Slowly, market practice and standardised tools have emerged, for example the use of CVA desks. However, during the recent crisis, another issue came to prominence, the significant losses that counterparty credit risk can cause if not managed properly. In response to this pressing matter, regulators have developed a number of alternative approaches to measure this new type of risk, including both standard default risk and market risk, leading to various types of capital requirements.