Magazine article The RMA Journal

Economic Capital for Counterparty Credit Risk

Magazine article The RMA Journal

Economic Capital for Counterparty Credit Risk

Article excerpt

A tutorial on identifying, measuring, and allocating capital for counterparty risk, this article helps position both counterparty exposure and economic capital by contrasting them with loans. The author presents several approaches to calculating economic capital for counterparty risk.

Like all forms of credit risk, counterparty risk is the risk that an obligor will be unable of unwilling to meet its contractual obligations. The primary distinguishing features of counterparty risk are that the magnitude (and the sign) of the credit exposure to a counterparty on any future date is uncertain. It depends on the market value of the contracts with the counterparty on that future date, which in turn depends on the potential future state of the market, which cannot be known with certainty today.

The potential credit exposure that a firm may have to each of its counterparties at each future date depends on the potential state of market rates at that future date, the effect that changes in market rates have on the value of the contracts with the counterparty, and the effect of any legally enforceable risk mitigant agreements (such as netting, margin, or option to early termination) on the exposure.

Firms with Counterparty Risk

The parties that enter into derivative contracts have a range of characteristics. At two extremes are simple end-users and very large market-makers:

1. The simplest end-user will enter into one or at most a few derivative contracts to hedge a single market rate (e.g., the U.S. dollar/Japanese yen exchange rate). If such a firm enters into more than one derivative, it will do so in a single direction (e.g., to hedge the risk of a fall in the yen) and for roughly the same tenor.

2. A very large derivative market-maker will enter into a multitude of types of OTC derivative contracts (e.g., forwards, swaps, and options) on a very large set of underlying market rates (e.g., yield curves, spot exchange rates, equity indices, specific equities, the credit risk of specific obligors, and commodity prices), in different directions (buying and selling), for different tenors, with a large number of counterparties.

Many market participants have characteristics that fall in between a simple end-user and a very large derivative market maker. The nature of the counterparty's portfolio is part of the context that needs to be assessed in ascertaining the appropriate method to measure counterparty exposure and economic capital for counterparty risk.

Contrasting Lending Risk and Counterparty Credit Risk

Counterparty credit exposure differs materially from loan portfolio exposure in several respects:

* The magnitude and the sign of future credit exposure depend on the future state of the market, which is not certain. At best we can describe the potential range, or probability distribution, that market rates could have at a future date, given their historical volatilities and correlations. Consequently, the potential future exposure to a counterparty can best be described statistically, as a potential exposure profile over time, measured at some high confidence level. In contrast, the exposure of a bullet loan is certain.

* For a very large derivative market-maker with multiple counterparties, not every derivative counterparty of the bank can have a positive mark-to-market value at the same time. Some counterparties will have trades that are, on net, in offsetting directions to the net trades of other counterparties (i.e., some counterparties may want protection for a decrease in the yen, others for an increase in the yen). In contrast a bank has credit exposure to all of its loan obligors at the same time.

* The market value of a forward or swap with a counterparty could potentially be positive of negative, depending on the future state of the market. Consequently, unlike with a loan, either party to a forward or a swap could potentially have a credit loss to the other. …

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