Topics 24-26

Question 1

Describe counterparty risk and differentiate it from lending risk

Answer 1

Counterparty risk is the risk that a counterparty is unable or unwilling to live up to its contractual obligations (i.e., counterparty defaults).

Lending risk has two notable characteristics:

• (1) the principal amount at risk is usually known with reasonable certainty (e.g., mortgage at a fixed rate) and
• (2) only one party (unilateral) takes on risk.

Counterparty risk goes further than lending risk because it takes into account that the value of the underlying instrument is uncertain in terms of absolute amount and in terms of which party will have a subsequent gain or loss. In addition, counterparty risk is bilateral in that each party takes on the risk that the counterparty will default; the party that is “winning” takes on the risk that the party that is “losing” will default.

Question 2

Repos, reverse repos, haircut and counterparty risk

Answer 2

Repos are short-term lending agreements (as short as one day) secured by collateral. The agreement involves a party (the seller or borrower) selling securities to another party (the buyer or lender) for cash, with the seller/borrower buying back the securities at a later date. The lender receives the repo rate, calculated as a risk-free interest charge, plus a counterparty risk charge. Collateral is usually in the form of liquid securities.

A haircut is applied to mitigate against the counterparty risk that the borrower will not repay the cash and to mitigate against a decline in the value of the collateral. To illustrate the use of a haircut, assume a 2% haircut on a $100 million loan amount. This means that approximately $102.04 million of securities is required as collateral on a $100 million loan [$100 million / (1 - 0.02) = $102.04 million].

Although reduced by collateral on the loan, counterparty risk still exists in both a repo transaction and a reverse repo transaction (which is a repo, from the perspective of the other party) due to the fact that the seller may fail to repurchase the security at the maturity date (forcing the buyer to liquidate the collateral to recover the cash that was loaned). If securities are used as collateral, risk exists that the market value of the securities will have declined prior to maturity.

Question 3

Counterparty risk of foreign exchange forwards

Answer 3

Foreign exchange forwards carry large counterparty risk due to the need to exchange notional amounts and due to long maturities (thereby increasing the probability that a default will occur at least once).

Question 4

Wrong-way risk (in CDS)

Answer 4

Wrong-way risk refers to an increase in exposure when counterparty credit quality worsens.

It can be illustrated in a very simplified example whereby a firm invested in Greek sovereign debt wishes to protect its position by purchasing a CDS on Greek sovereign debt from a Greek bank. Assuming a reduction in the rating of Greek sovereign debt, the buyer of the CDS is “winning.” However, the ability of the “losing” counterparty (the Greek bank) to meet its obligations will further be impaired as a result of the credit rating decrease.

Question 5

Identify and describe institutions that take on significant counterparty risk

Answer 5

• Large derivatives players are large banks (dealers) that trade with each other and with a large number of clients. They tend to have high numbers of OTC derivatives on their books and cover a very wide range of assets, including commodities, equity, foreign exchange, interest rate, and credit derivatives. In addition, they will post collateral against their positions.
• Medium derivatives players are often smaller banks or financial institutions that also have a large number of clients and conduct a high volume of OTC derivatives trades. While they also cover a wide range of assets, they are not as active in all of them as large players. In addition, it is likely (but not definite) that they will post collateral against positions.
• Small derivatives players are sovereign entities, large corporations, or smaller financial institutions with specific derivatives requirements that determine the trades they undertake. Trades are done with only a small number of counterparties, and, as expected, they have few OTC derivatives trades on their books. Unlike large and medium players, small players are likely to specialize in just one asset class. They will also differ from larger players in terms of collateral, which if posted will often be illiquid.

Question 6

Describe credit exposure, credit migration, recovery, mark-to-market, replacement cost, default probability, loss given default, and the recovery rate

Answer 6

Credit exposure (or simply exposure) is the loss that is “conditional” on the counterparty defaulting.

Regarding credit migration, the counterparty may default or its credit rating may deteriorate over the term of the contract, especially for long-time horizons. Alternatively, there may be an improvement in credit rating over time. To assess credit migration, we must consider the term structure of default probability:

• Future default probability will likely decrease over time, especially for periods far into the future. This is due to the higher likelihood that the default will have already occurred at some earlier point.
• An expected deterioration in credit quality suggests an increasing probability of default over time.
• An expected improvement in credit quality suggests a decreasing probability of default over time.

Empirically, there is mean reversion in credit quality.

Recovery is measured by the recovery rate, which is the portion of the outstanding claim actually recovered after default.

Mark to market (MtM) is an accrual accounting measure that is equal to the sum of the MtM values of all contracts with a given counterparty. Although in theory it represents the current potential loss, it fails to consider other factors such as netting, collateral, or hedging. MtM is equal to the present value of all expected inflows less the present value of expected payments (positive if in favor of the party and negative if not). MtM is a measure of replacement cost. However, although generally close, current replacement cost is not theoretically the same as the MtM value due to factors such as transaction costs and bid-ask spreads.

Question 7

Ways to manage Counterparty Risk

Answer 7

Methods to manage counterparty risk include the following: trading only with high-quality counterparties, cross-product netting, close-out, collateralization, walkaway features, diversifying counterparty risk, and exchanges and centralized clearinghouses.

• Cross-product netting works with derivative transactions that can have both a positive and a negative value. In the case of a default by either counterparty, a netting agreement will allow transactions to be aggregated and reduce the risk for both parties. The legal and operational risks that accompany netting must be considered.
• Close-out is the immediate closing of all contracts with the defaulted counterparty. When combined with netting of MtM values, an institution may offset what it owes to the counterparty (a negative amount) against what it is owed by the counterparty (a positive amount). If the net amount is negative, the institution will make a payment, but if the net amount is positive, it will make a claim. This results in an immediate realization of net gains or losses for the institution.
• Posting collateral is done on a periodic basis to minimize transaction costs. However, collateralization does come with market, operational, and legal risks as well as significant work requirements to ensure the process is done properly.
• A walkaway feature allows a party to cancel the transaction if the counterparty defaults. It is advantageous if a party has a negative MtM and the counterparty defaults.
• Diversification of counterparty risk limits credit exposure to any given counterparty consistent with the default probability of the counterparty.

Question 8

Ways to mitigatie Counterparty Risk

Answer 8

• As mentioned, netting is commonly used to mitigate counterparty risk.
• A second way to mitigate counterparty risk is the use of collateralization.
• A third way to mitigate counterparty risk is through hedging. Using credit derivatives allows an organization to reduce counterparty exposure to its own clients in exchange for increasing counterparty exposure to clients of a competitor. Therefore, hedging generates market risk.
• Central counterparties (e.g., exchanges and clearinghouses) frequently take on the role of the counterparty, which offers another way to mitigate counterparty risk.

Question 9

Quantifying Counterparty Risk, CVA

Answer 9

In general, counterparty risk for a given transaction is quantified on the following levels:

• Trade level: considers the nature of the trade and related risk factors.
• Counterparty level: takes into account risk mitigating factors such as netting and collateral for each individual counterparty.
• Portfolio level: considers overall counterparty risk in that only a small percentage will likely default in a given time period.

Within the context of derivatives pricing, there is a portion that assumes no counterparty risk and a portion that accounts for counterparty risk. The portion that accounts for counterparty risk is known as the credit value adjustment (CVA). A trader’s objective is to earn a return greater than the CVA.

The CVA is a complex calculation that takes into account the following elements:

• Default probability of the party itself.
• Default probability of the counterparty.
• Nature of the transaction.
• Netting of existing transactions with the same counterparty.
• Any existing collateralization.
• Any existing hedging positions.

Question 10

Explain the purpose of an ISDA master agreement

Answer 10

The International Swaps and Derivatives Association (ISDA) Master Agreement standardizes over-the-counter (OTC) agreements to reduce legal uncertainty and mitigate credit risk.

Question 11

Netting and Close-Out Between Two Counterparties

Answer 11

Netting, often called set-off, generally refers to combining the cash flows from different contracts with a counterparty into a single net amount. This is referred to as payment netting, which acts to reduce settlement risk while enhancing operational efficiency.

A related concept is close-out netting, which refers to the netting of contract values with a counterparty in the event of the counterparty’s default.

The concepts of both netting and close-out incorporate two related rights under a single contract:

(1) the right to terminate contracts unilaterally (by only one side) under certain conditions (close-out) and
(2) the right to offset (net) amounts due at termination into a single sum.

Without netting, overall exposure is additive as the sum of the positive mark-to-market values. With netting, exposures of trades are not additive, which significantly reduces risk.

Question 12

Advantages and Disadvantages of Netting

Answer 12

Netting has several advantages and disadvantages:

• Exposure reduction
• Unwinding positions:. If an entity wishes to exit a less liquid OTC trade with one counterparty by entering into an offsetting position with another counterparty, the entity will remove market risk; however, it will be exposed to counterparty and operational risk. Netting removes these risks through executing a reverse position with the initial counterparty, removing both market and counterparty risk. The downside is that the initial counterparty, knowing that the entity is looking to exit a trade, may impose less favorable terms for the offsetting transaction.
• Multiple positions:. An entity can reduce counterparty risk, obtain favorable trade terms, and reduce collateral requirements by trading multiple positions with the same counterparty.
• Stability: Without netting, entities trading with insolvent or troubled counterparties would be motivated to cease trading and terminate existing contracts, exacerbating the financial distress of the counterparty. With netting, this risk is significantly reduced, and an agreement with a troubled counterparty is more achievable.

Question 13

Close-out and acceleration clauses

Answer 13

• Close-out arrangements protect the solvent, or surviving, entity. Note that close-out differs from an acceleration clause, which allows the creditor to accelerate (i.e., make immediately due) future payments given a credit event, such as a ratings downgrade. In contrast to acceleration, close-out clauses allow all contracts between a solvent and insolvent entity to be terminated, which effectively cancels the contracts and creates a claim for compensation.
• Both acceleration and close-out clauses have been criticized for making a debtor’s refinancing more difficult. Both clauses cause payment amounts to be immediately due and may speed up the financial distress of the insolvent entity.
• For this reason, courts may impose a stay (temporary suspension) on the agreements to allow for a short period of “time out” while maintaining the validity of the termination clauses.
• Despite these criticisms, close-out clauses can be very advantageous to parties. Close-out limits the uncertainty in the value of an entity’s position with an insolvent counterparty.
• In addition, close-out allows entities to freeze their exposures. Because these exposure amounts are known and will not fluctuate, the solvent entity can then better hedge this exposure.

Question 14

Describe the effectiveness of netting in reducing credit exposure under various scenarios

Answer 14

A trading instrument will have a beneficial effect on netting if it can have a negative mark-to-market (MtM) value during its life.

For instruments whose MtM value can only be positive during their life, the effect on netting will not be as beneficial.

• Instruments with only positive MtM values include options with up-front premiums such as equity options, as well as swaptions, caps and floors, and FX options.
• Other instruments can have negative MtM value during their life; however, there is a greater likelihood that MtM will be positive. These instruments include long options without up-front premiums, certain interest rate swaps, certain FX forwards, cross-currency swaps, off-market instruments, and wrong-way instruments.

Despite these instruments having either only positive or mostly positive MtM values, it may still be worthwhile for an entity to include them under a netting agreement for the following reasons:

• Future trades with negative MtM values could offset the positive MtM of these instruments.
• Inclusion of all trades is necessary for effective collateralization.
• Netting is beneficial as it ensures that if these positions need to be unwound in the future and an offsetting (mirror) trade is required, there will be no residual counterparty risk.

Question 15

Reset agreement

Answer 15

Termination events allow institutions to terminate a trade before their counterparties become bankrupt.

A reset agreement readjusts parameters for trades that are heavily in the money by resetting the trade to be at the money. Reset dates are typically linked with payment dates, but they could also be triggered after a certain market value is breached.

As an example, consider a resettable cross-currency swap. With this trade, the MtM value of the swap is exchanged at each reset date. In addition, the foreign exchange rate, which influences the swap’s MtM value, is reset to the current spot rate. This reset will end up changing the notional amount for one leg of the swap.

Question 16

Additional termination events (ATEs), Break clauses

Answer 16

Additional termination events (ATEs), which are sometimes referred to as break clauses, are another form of a termination event, which allow an institution to terminate a trade if the creditworthiness of their counterparty declines to the point of bankruptcy.

More specifically, a break clause (also called a liquidity put or early termination option) allows a party to terminate a transaction at specified future dates at its replacement value. Break clauses are often bilateral, allowing either party to terminate a transaction, and are useful in providing an option to terminate transactions—particularly long-dated trades—without cost when the quality of the counterparty declines. Events to trigger a break clause generally fall into three categories:

• Mandatory. The transaction will terminate at the date of the break clause.
• Optional. One or both counterparties have the option to terminate the transaction at the pre-specified date.
• Trigger-based. A trigger, like a ratings downgrade, must occur before the break clause may be exercised.

Despite their advantages, break clauses have not been highly popular. One explanation is that break clauses, in effect, represent a discrete form of collateralization; however, collateralization can be better achieved by the continuous posting of collateral.

Another explanation is known as “banker’s paradox,” which implies that for a break clause to be truly useful, it should be exercised early on, prior to the substantial decline in a counterparty’s credit quality. Entities, however, typically avoid early exercise to preserve their good relationships with counterparties.

Question 17

Walkaway clauses

Answer 17

Walkaway clauses allow an entity to benefit from the default of a counterparty. Specifically, under these clauses an entity can walk away from, or avoid, its net liabilities to a counterparty that is in default, while still being able to claim in the event of a positive MtM exposure.

They have been criticized for creating additional costs for a counterparty in the event of a default, for creating moral hazard, and, because a walkaway feature may already be priced in a transaction, hiding some of the risks in a transaction. For these reasons, these clauses should be ultimately avoided.

Question 18

Trade Compression

Answer 18

An approach for utilizing multilateral netting without the need for a membership organization is trade compression. Because portfolios often have redundancies among trades with multiple counterparties, compression aims to r_educe the gross notional amount and the number of trades_ (e.g., OTC derivatives transactions). Thus, trade compression can reduce net exposure without the need to change an institution’s overall risk profile.

Trade compression requires participants to submit applicable trades for compression along with their desired risk tolerance. The submitted trades are then matched to each counterparty and netted into a single contract.

For example, consider an institution with three credit default swap (CDS) contracts for the same reference entity and maturity, but with different counterparties. In this case, the three trades can be compressed into a single net contract by netting out the long and short contracts and using the weighted average of the three contract coupons as the net contract coupon. Trade compression services, such as TriOptima, help reduce OTC derivatives exposures for various credit derivatives. In addition, recent changes to the CDS market, such as standard coupons and maturity dates, also help promote the benefits of trade compression.

Question 19

Describe the rationale for collateral management

Answer 19

Collateral is an asset supporting a risk in a legally enforceable way.

Collateral management is often bilateral, where either side to a transaction is required to post or return collateral to the side with the positive exposure.

There are essentially four motivations for managing collateral:

1. reduce credit exposure to enable more trading,
2. have the ability to trade with a counterparty (e.g., restrictions on credit ratings may preclude an entity from trading on an uncollateralized basis),
3. reduce capital requirements, and
4. allow for more competitive pricing of counterparty risk.

Question 20

Describe the terms of a collateral agreement and features of a credit
support annex (CSA) within the ISDA Master Agreement including threshold, initial margin, minimum transfer amount and rounding, haircuts, credit quality, and credit support amount

Answer 20

The purpose of a credit support annex (CSA) incorporated into an ISDA Master Agreement is to allow the parties to the agreement to mitigate credit risk through the posting of collateral.

Because collateral can vary greatly in terms of amount, liquidity, and risk levels (as well as many other elements), a CSA is created to govern issues such as collateral eligibility, interest rate payments, timing and mechanics associated with transfers, posted collateral calculations, haircuts to collateral securities (if applicable), substitutions of collateral, timing and methods for valuation, reuse of collateral, handling disputes, and collateral changes that may be triggered by various events.

Parameters established with CSAs (and collateralized agreements in general) include the following:

• Threshold: Collateral will be posted when the level of MtM exposure exceeds this threshold level.
• Initial margin (also known as independent amount in bilateral markets): The amount of extra collateral that is required independent of the level of exposure.
• Minimum transfer amount: The minimum amount of collateral that can be called at a given time.
• Rounding: Collateral calls or collateral returns may be rounded to specific sizes to avoid working with inconvenient quantities.
• Haircut: This reduces the value of collateral to account for the possibility that its price may fall between the previous collateral call and a counterparty default.
• Credit quality: As counterparty credit quality declines, the importance of collateral increases.
• Credit support amount: The amount of collateral that may be called (by either counterparty) at a certain point in time.

Question 21

Describe the role of a valuation agent

Answer 21

The valuation agent is responsible for calling for the delivery of collateral and handles all calculations.

The valuation agent’s role is to calculate

1. credit exposure,
2. market values,
3. credit support amounts, and
4. the delivery or return of collateral.

Larger entities often insist on being valuation agents when dealing with smaller counterparties. When the size difference between counterparties is small, both counterparties may be valuation agents. In this case, each entity would call for collateral when they have positive exposure; however, this could lead to disputes and delays in processing collateral movements. One remedy is to use a third-party valuation agent that would handle the collateral process, processing collateral substitutions, resolving disputes, and producing daily valuation reports.

Question 22

Explain the process for the reconciliation of collateral disputes

Answer 22

To mitigate risk, it is generally preferred to include the maximum number of trades in collateral agreements. However, if even a single trade cannot be properly valued, it can complicate collateral calls and may lead to collateral disputes. If trades include potentially problematic assets, it may be optimal to only focus on a subset of trades that make up the majority of credit exposure and leave out asset classes that are hard to value either due to complexity (e.g., exotic options) or illiquidity (e.g., credit derivatives).

If an entity expects one of its counterparties to have difficulty valuing certain trades or assets, it may be preferred to leave those trades uncollateralized rather than face potential and frequent disputes.

If disputes do arise, they can relate to the trade population, trade valuation, netting rules, market data and market closing time, and valuing collateral that was previously posted. If the disputed amount or valuation difference is small, counterparties may simply split the difference. If the disputes involve larger differences, the exposure will remain uncollateralized until the dispute is resolved.

Disputes include the following steps:

1. the disputing party notifies the counterparty of its intent to dispute the exposure by the end of the day following the collateral call;
2. all undisputed amounts are transferred, and the reason for the dispute is identified; and
3. for unresolved disputes, the parties will request quotes from several market makers (usually four) for the MtM value.

Question 23

Explain the features of a collateralization agreement

Answer 23

Counterparties most commonly link a tightening of collateral terms to changes in credit rating (e.g., to a downgrade in rating to below investment grade). While this approach is easy to set up, it can lead to issues by requiring the downgraded counterparty to post collateral exactly at a time when it is experiencing credit issues. This can lead to a “death spiral” of the affected counterparty, as the counterparty faces multiple collateral calls. As a result, it may be preferable to link collateral terms not to the credit rating of entities, but to credit spreads, the market value of equity, or net asset values.

While longer margin frequencies likely reduce operational workloads, daily margining has, more or less, become the market norm.

Threshold in margining refers to the level of exposure below which collateral will not be called. As a result, threshold represents the level of uncollateralized exposure, and only the incremental amount above the threshold would be collateralized. Thresholds generally aim to reduce the operational burden of calling collateral too frequently. Thresholds are most often linked to credit ratings in a tiered manner, with lower credit ratings corresponding to lower or zero threshold amounts.

Initial margin is the collateral amount that is posted upfront and is “independent” of any subsequent collateralization. It is often used to mitigate the widening of credit spreads or declines in equity values. Initial margin is typically required by stronger credit quality counterparties or by the counterparty more likely to have positive exposures and represents a level of overcollateralization. Intiail margins can be thought of as converting counterparty risk into gap risk, ensuring that the less risky counterparty always remains overcollateralized by this amount without incurring losses, even when the risky counterparty defaults. Initial margins should, therefore, be large enough to minimize the gap from large value movements of trades should the risky counterparty default.

A minimum transfer amount represents the smallest amount of collateral that can be transferred. A minimum transfer amount is used to reduce the operational workload of frequent transfers for small amounts of collateral, which must be balanced against the benefits of risk mitigation. It is important to note that the threshold and minimum transfer amount are additive; that is, exposure must exceed the sum of both before a collateral call can be made.

Collateral amounts typically use rounding (e.g., to the nearest thousand) to avoid transferring very small amounts during collateral calls or returns.

A haircut is essentially a discount to the value of posted collateral. In other words, a haircut of x% means that for every unit of collateral posted, only (1 — x)% of credit will be given. This credit is also referred to as valuation percentage. Cash typically has a haircut of 0% and a valuation of 100%, while riskier securities have higher haircut percentages and lower corresponding valuation percentages.

Question 24

Substitution and Rehypothecation

Answer 24

Counterparties sometimes require that the original posted collateral be returned to them for various reasons, including meeting certain delivery commitments. In this case, they can make a substitution request by posting an equivalent value of some other eligible collateral. Substitution requests cannot be refused by the other party if the substituted collateral meets all eligibility criteria. Noncash collateral may also be sold, used in repo transactions, or rehypothecated.

Rehypothecation refers to transferring posted collateral to other counterparties as collateral. While widespread, rehypothecation carries two related risks. Consider a scenario where party A pledges collateral to party B; party B rehypothecates this collateral to party C. If party C defaults, then party B will not only have a loss from not receiving the collateral from party C, it will also have a liability to party A for not returning its collateral. The practice of rehypothecation was relatively widespread prior to the 2007-08 credit crisis; however, it has been significantly less popular following the crisis. Parties now increasingly prefer cash collateral.

Question 25

Differentiate between a two-way and one-way CSA agreement and describe how collateral parameters can be linked to credit quality

Answer 25

• A two-way CSA is often established when two counterparties are relatively similar, as it will be beneficial to both parties involved. It is important to note that the two sides may not be treated equally, as certain key parameters (like threshold and initial margin) may differ depending on the respective risk levels of each party.
• A one-way CSA differs from a two-way CSA in that the former only requires that one counterparty post collateral (either immediately or after a specific event, such as a ratings downgrade). As a result, the CSA will be beneficial to the receiver of the collateral and at the same time will present additional risk for the counterparty posting the collateral. These types of CSAs are established when two counterparties are significantly different in size, risk levels, et cetera.
• The terms of a collateral agreement are usually linked to the credit quality of the counterparties in a transaction. This is beneficial when a counterparty’s credit quality is strong because it minimizes operational workload. However, it is also beneficial when a counterparty’s credit quality is weak as it allows the other party to enforce collateralization terms triggered by a quality downgrade.

Question 26

Explain how market risk, operational risk, and liquidity risk (including funding liquidity risk) can arise through collateralization

Answer 26

Use of collateral may be viewed as a double-edged sword. When managed properly, it can mitigate risks, but when managed poorly, it may well give rise to additional risks.

Collateral agreements could potentially cause the following risks.

• Market Risk

Market risk relates to the degree of market movements that have occurred since the last posting of collateral. It is relatively small compared to the risk of an uncollateralized situation, but market risk is a challenge to hedge and to quantify.

• Operational Risk

​Potential pitfalls in the handling of collateral include missed collateral calls, failed deliveries, computer error, human error, and fraud. Proper controls must be in place to reduce the likelihood of the occurrence of any one of the foregoing items.

• Liquidity and Liquidation Risk

Transaction costs may result when having to liquidate collateral to mitigate counterparty risk. These are often in the form of a bid-ask spread or selling costs. Liquidating a security in an amount that is large relative to its typical trading volume may negatively impact its price, leading to a substantial loss. The alternative is to liquidate a position slowly. With this approach, the counterparty is exposed to market volatility during the period of liquidation.

• Funding Liquidity Risk

Funding liquidity risk refers to the ability of an institution to settle its obligations quickly when they become due, which results from the funding needs established in a CSA. For various reasons, collateral agreements are not in place for many OTC derivatives transactions. When a counterparty does not have the operational capacity or liquidity to handle frequent collateral calls (required under a CSA), the counterparty will be vulnerable to funding implications. This risk is relatively small when markets are liquid and funding costs are low. However, when markets are illiquid, the risks become higher because funding costs can increase considerably.

• Default Risk

The default of a security posted as collateral will lower its value (when the loss in value is unlikely to be covered by a haircut).

• Foreign Exchange Risk

Foreign exchange risk occurs when counterparties have different currencies.