Counterparty Risk

Question 1

What is the definition of credit counterparty risk?

Answer 1

1. If is the risk that a counterparty in OTC derivatives or security financing transaction will default prior to expiration of a trade and will not therefore make the current and future payments required by the contract.
2. The future exposure, i.e. the value of the derivative at the potential event of default of the counterparty, is highly uncertain.
3. Since the futural value of the contract may be positive or negative, the risk is bilateral.

Question 2

What is credit exposure?

Answer 2

1. Credit exposure defines the loss in the event of a counterparty defaulting
2. It corresponds to the EAD (Exposure at Default) concept in lending risk, and is therefore a risk measure conditional on default

Question 3

What does the value (positive vs negative) of an OTC derivative signify?

Answer 3

1. The positive value of an OTC derivative corresponds to a claim on the defaulted counterparty.
2. In the event of negative value an institution cannot walk away
3. This means that if an institution is owed money and their counterparty defaults they will incur a loss, whilst in the reverse situation they cannot gain from the default by being somehow released from their liability.

Question 4

What is the process for counterparty default if MtM is positive?

Answer 4

1. We file (with other creditors) a claim with the trustee for the MtM amount
2. We replace the OTC derivative with one identical, with the same MtM and uprfont loss
3. Immediate loss equal to the MtM

Question 5

What is the process for counterparty default if MtM is negative?

Answer 5

1. We pay to the trustee the MtM
2. We replace the OTC derivative with one identical, with same MtM and upfront gain
3. Zero economic impact

Question 6

What is the formula for credit exposure measured as replacement cost?

Answer 6

CE(τ) = Max (MtM_τ,0) = MtM⁺

Question 7

What is the formula for potential future exposure (PFE)?

Answer 7

PFE_c(t₁) = inf{MtM belongs to R: P(MtM_t1 > MtM) <= 1-c}

Question 8

What is the formula for expected exposure in credit counterparty risk?

Answer 8

EE(t₁) = E_t[MtM_t1|MtM_t1 > 0]

Question 9

What is the formula for the maximum (peak) PFE?

Answer 9

PFE_{c, Peak} = max_{t less than t 1 less than T} (PFE_c(t₁))

Question 10

What are the four popular techniques for mitigating counterparty risk?

Answer 10

1. Close-out netting
2. Usage of collateral
3. Central Counterparts
4. Portfolio Compression

Question 11

What is close-out?

Answer 11

Close–out:
termination of all contracts between the solvent and insolvent counterparty
at the time of default.
Termination cancels the contract and creates a claim for compensation
based on the cost of replacing the contract on identical terms with another
(solvent) counterparty.

Question 12

What is the formula for expected positive exposure?

Answer 12

At time t, given an OTC derivative with maturity T:
EPE = (1/N) * Sigma_N(EE(t_i))

Question 13

What is margin period of risk when posting collateral in credit counterparty risk management?

Answer 13

Margin Period of Risk is the time gap allowed between last collateral
deposit by the defaulted counterpart and the default time.

Question 14

What is unwinding an OTC derivative?

Answer 14

The termination of a derivative by marking it to market and calculating
its value in order to determine which counterparty has a positive terminal
value.
This counterparty will receive cash payment from the other counterparty
whose terminal value is negative

Unwinding can be a costly process, so compression is often used