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Counterparty Credit Risk and Credit Value Adjustment: A Continuing Challenge for Global Financial Markets, 2nd Edition

ISBN: 978-1-118-31667-2
480 pages
October 2012
Counterparty Credit Risk and Credit Value Adjustment: A Continuing Challenge for Global Financial Markets, 2nd Edition (1118316673) cover image
A practical guide to counterparty risk management and credit value adjustment from a leading credit practitioner

Since the collapse of Lehman Brothers and the resultant realization of extensive counterparty risk across the global financial markets, the subject of counterparty risk has become an unavoidable issue for every financial institution. This book explains the emergence of counterparty risk and how financial institutions are developing capabilities for valuing it. It also covers portfolio management and hedging of credit value adjustment, debit value adjustment, and wrong-way counterparty risks. In addition, the book addresses the design and benefits of central clearing, a recent development in attempts to control the rapid growth of counterparty risk. This uniquely practical resource serves as an invaluable guide for market practitioners, policy makers, academics, and students.

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Acknowledgements xvii

List of Spreadsheets xix

List of Appendices xxi

SECTION I INTRODUCTION 1

1 Introduction 3

2 Background 9

2.1 Introduction 9

2.2 Financial risk 9

2.3 Value-at-Risk 11

2.4 The derivatives market 14

2.5 Counterparty risk in context 18

2.6 Summary 20

3 Defining Counterparty Credit Risk 21

3.1 Introducing counterparty credit risk 21

3.2 Components and terminology 30

3.3 Control and quantification 34

3.4 Summary 40

SECTION II MITIGATION OF COUNTERPARTY CREDIT RISK 41

4 Netting, Compression, Resets and Termination Features 45

4.1 Introduction 45

4.2 Netting 46

4.3 Termination features and trade compression 51

4.4 Conclusion 57

5 Collateral 59

5.1 Introduction 59

5.2 Collateral terms 64

5.3 Defining the amount of collateral 71

5.4 The risks of collateralisation 74

5.5 Summary 77

6 Default Remote Entities and the Too Big to Fail Problem 79

6.1 Introduction 79

6.2 Special purpose vehicles 82

6.3 Derivative product companies 82

6.4 Monolines and credit DPCs 84

6.5 Central counterparties 93

7 Central Counterparties 97

7.1 Centralised clearing 97

7.2 Logistics of central clearing 105

7.3 Analysis of the impact and benefits of CCPs 113

7.4 Conclusions 118

8 Credit Exposure 121

8.1 Credit exposure 121

8.2 Metrics for credit exposure 126

8.3 Factors driving credit exposure 130

8.4 Understanding the impact of netting on exposure 138

8.5 Credit exposure and collateral 143

8.6 Risk-neutral or real-world? 150

8.7 Summary 153

SECTION III CREDIT VALUE ADJUSTMENT 155

9 Quantifying Credit Exposure 157

9.1 Introduction 157

9.2 Methods for quantifying credit exposure 157

9.3 Monte Carlo methodology 159

9.4 Models for credit exposure 165

9.5 Netting examples 170

9.6 Allocating exposure 175

9.7 Exposure and collateral 185

9.8 Summary 195

10 Default Probability, Credit Spreads and Credit Derivatives 197

10.1 Default probability and recovery rates 197

10.2 Credit default swaps 211

10.3 Curve mapping 217

10.4 Portfolio credit derivatives 220

10.5 Summary 224

11 Portfolio Counterparty Credit Risk 225

11.1 Introduction 225

11.2 Double default 225

11.3 Credit portfolio losses 229

11.4 Summary 239

12 Credit Value Adjustment 241

12.1 Definition of CVA 242

12.2 CVA and exposure 246

12.3 Impact of default probability and recovery 250

12.4 Pricing new trades using CVA 252

12.5 CVAwith collateral 260

12.6 Summary 263

13 Debt Value Adjustment 265

13.1 DVA and counterparty risk 265

13.2 The DVA controversy 271

13.3 How to monetise DVA 274

13.4 Further DVA considerations 277

13.5 Summary 281

14 Funding and Valuation 283

14.1 Background 283

14.2 OIS discounting 285

14.3 Funding value adjustment 290

14.4 Optimisation of CVA, DVA and funding costs 299

14.5 Future trends 304

14.6 Summary 306

15 Wrong-Way Risk 307

15.1 Introduction 307

15.2 Overview of wrong-way risk 307

15.3 Portfolio wrong-way risk 314

15.4 Trade-level wrong-way risk 319

15.5 Wrong-way risk and credit derivatives 331

15.6 Summary 337

SECTION IV MANAGING COUNTERPARTY CREDIT RISK 339

16 Hedging Counterparty Risk 341

16.1 Background to CVA hedging 342

16.2 Components of CVA hedging 346

16.3 Exposure hedges 349

16.4 Credit hedges 354

16.5 Cross-dependency 357

16.6 The impact of DVA and collateral 362

16.7 Summary 368

17 Regulation and Capital Requirements 371

17.1 Introduction 371

17.2 Basel II 372

17.3 Exposure under Basel II 375

17.4 Basel III 384

17.5 Central counterparties 399

17.6 Summary 401

18 Managing CVA – The “CVA Desk” 403

18.1 Introduction 403

18.2 The role of a CVA desk 404

18.3 CVA charging 410

18.4 Technology 415

18.5 Practical hedging of CVA 419

18.6 Summary 425

19 The Future of Counterparty Risk 427

19.1 Key components 427

19.2 Key axes of development 430

19.3 The continuing challenge for global financial markets 432

References 435

Index 443

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Jon Gregory is an experienced practitioner in the area of financial risk management. From 1995 to 1997 he worked in the Fixed Income division of Salomon Brothers. From 1997 to 2005 he was with BNP Paribas and from 2005 until 2008 he was global head of credit analytics at Barclays Capital. Jon has published a number of papers and articles on risk management, credit derivatives and quantitative finance and is a regular speaker at international conferences. He was a co-author of the book Credit: A Complete Guide to Pricing, Hedging and Risk Management, nominated in 2001 for the Kulp-Wright award for the most significant text in risk management and insurance. He is currently a partner at Solum Financial based in London and advises a number of banks on their counterparty risk and CVA practices. He holds a PhD from Cambridge University.

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