Counterparty Credit Risk Flashcards
what is counterparty credit risk
the risk of being unable to meet contractual obligations
what are 3 characteristics of CCR
- Comes from the interaction between credit risk and market risk.
- Bilateral since contract value can be positive or negative.
- Uncertainty in both magnitude and direction.
what are 6 ways to mitigate CCR
- netting
- margin agreements
- initial margin
- diversification
- guarantees
- trading through the CCP
what is one advantage and 2 disadvantages of netting
advantage: stability as a counterparty enters financial distress
disadvantages: exposures may become more volatile, unwinding of contracts may be difficult
what is a margin agreement
a legal bilateral agreement to settle the MtM at zero
what is the initial margin and when is it used
it is a legal special type of collateral
typically used when a weaker counterparty deals with a stronger one.
how is diversification used in mitigating CCR
diversify using time (different maturity dates) since a counterparty can only default at one point in time.
what is a replacement cost
the amount left in the loan that the creditor is at risk of
give the formulas for portfolio exposure with and without netting
Portfolio exposure with netting:
E=max(∑ MtM_i,0)
Portfolio exposure without netting:
E=∑ max(MtM_i,0)
what does potential future exposure do
monitors the credit limit of the counterparty
what is wrong way risk
credit spreads may be correlated with market conditions
what are the 2 types of wrong way risk
- Specific
- General
what are 3 exm=amples of specific wrong-way risk
o A short position on a company with its own equity.
o Purchasing credit protection from a company on its own default.
o A sovereign posts its own bonds as collateral.
what is general wrong-way risk
risk inferred from a general correlation, not a direct causal link
how can wrong-way risk be mitigated
using copulas to model the two distribution jointly
