Lecture 6 - Credit Risk - ENPC

counterparty risk management: for internal purpose and for regulatory capital .... An airline usually protects itself against a rise in fuel prices by entering into long.
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Counterparty – Introduction

Counterparty risk metrics

WWR and RWR

Counterparty risk mitigations

Credit Risk Lecture 6 – Counterparty risk Fran¸cois CRENIN

´ Ecole Nationale des Ponts et Chauss´ ees D´ epartement Ing´ enieurie Math´ ematique et Informatique (IMI) – Master II

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Counterparty – Introduction

Counterparty risk metrics

WWR and RWR

Counterparty risk mitigations

1 Counterparty – Introduction 2 Counterparty risk metrics 3 Wrong Way Risks and Right Way Risks 4 Counterparty risk mitigations

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Counterparty – Introduction

Counterparty risk metrics

WWR and RWR

Counterparty risk mitigations

Definition of the counterparty risk

Counterparty risk – Introduction Definition of the counterparty risk

Counterparty risk The counterparty risk is defined as the risk the counterparty to a transaction could default before the final settlement of the transaction’s cash flows. An economic loss would occur if the transactions or portfolio of transactions with the counterparty has a positive economic value at the time of default. [BCBS, 2006]

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Counterparty – Introduction

Counterparty risk metrics

WWR and RWR

Counterparty risk mitigations

Definition of the counterparty risk

Properties of the counterparty risk

Counterparty risk – A bilateral risk Unlike a firm’s exposure to credit risk through loan, where the exposure to credit risk is unilateral and only the lending bank faces the risk of loss, the counterparty credit risk creates a bilateral risk of loss: the market value of the transaction can be positive or negative to either counterparty of the transaction. [BCBS, 2006] Counterparty risk – A systemic risk I I

Derivatives create credit risk between the counterparties ; Derivatives increase the connectedness of the financial system.

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Counterparty – Introduction

Counterparty risk metrics

WWR and RWR

Counterparty risk mitigations

Definition of the counterparty risk

Counterparty risk – Introduction Counterparty risk as a systemic risk – Example

Counterparty risk during the 2008 financial crisis The 2008 financial crisis showed that counterparty-related losses (e.g. changes is credit spreads of the counterparties and changes in the market prices that drive the underlying derivative exposures) have been much larger than default losses.

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Counterparty – Introduction

Counterparty risk metrics

WWR and RWR

Counterparty risk mitigations

Definition of the counterparty risk

Counterparty risk – Introduction Drivers of counterparty risk

Drivers of counterparty risk Counterparty risk is affected by several complex risk drivers: I the Over the Counter (OTC) contract’s market value risk drivers; I the counterparty credit spread; I the correlation between the underlying and default of the counterparty.

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Counterparty – Introduction

Counterparty risk metrics

WWR and RWR

Counterparty risk mitigations

Definition of the counterparty risk

Counterparty risk – Introduction Counterparty risk – A comparative analysis with the lending business

Difference between the lending business and the derivatives business: I Loans: exposure at any future date is the outstanding balance, which is certain (without considering prepayments); I Derivatives: exposure at any future date is determined by the market value and the date is uncertain.

Counterparty risk can be: I Unilateral: one party (the investor) is considered default-free and only the exposure to the counterparty matters; I Bilateral: both parties are considered risky and face exposures depending on the value of the positions they hold against each other.

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Counterparty – Introduction

Counterparty risk metrics

WWR and RWR

Counterparty risk mitigations

The derivatives market

The derivatives market OTC derivatives – Pros and Cons

OTC derivatives – Pros and Cons OTC derivatives are efficient tools to transfer financial risks between market participants. As a by product of such a transfer: I they create credit risk between the counterparties; I they increase connectedness within the financial system.

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Counterparty – Introduction

Counterparty risk metrics

WWR and RWR

Counterparty risk mitigations

The derivatives market

The derivatives market The derivatives market – Figures

Source: www.bis.org

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Counterparty – Introduction

Counterparty risk metrics

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Counterparty risk mitigations

Introduction

Counterparty risk metrics The two purposes of counterparty risk metrics

Measuring counterparty risk can fulfill two purposes: I counterparty risk management: for internal purpose and for regulatory capital requirements, following Basel II; I counterparty risk from a pricing point of view: Credit Value Adjustment (CVA) is computed during the pricing to account for possible default of the counterparty.

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Counterparty – Introduction

Counterparty risk metrics

WWR and RWR

Counterparty risk mitigations

EEPE

Counterparty risk metrics Basic concepts

Let us denote V (t) the market value of a derivative or of several derivatives if a netting agreement is in place, at time t. Counterparty exposure is equal to E (t) = V (t)+ = max(0, V (t)). It is also known a Potential Future Exposure (PFE). Peak Exposure (PE) at level α PEα (t) = inf{X (t) |P [E (t) ≥ X (t)] ≤ 1 − α}

Expected Exposure (EE) EE(t) = EQ (E (t))

Effective Positive Exposure (EPE) EPE(t) =

1 t

t

Z

EE(s)ds 0

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Counterparty – Introduction

Counterparty risk metrics

WWR and RWR

Counterparty risk mitigations

EEPE

Counterparty risk metrics Basic concepts

Expected Effective Positive Exposure (EEPE) EEPE(t) =

1 t

Z

t

max(EE(h))ds 0

h 0 is the threshold below which, no collateral is posted. Margin period (δ) The marginal period is the interval at which margin is monitored and called for: C (t) = [E (t − δ) − H]

Minimum Transfer Amount - MTA The Minimum Transfer Amount is the amount below which no margin transfer is made: C (t) = [E (t − δ) − H] + 1{E (t−δ)−H>MTA}

Downgrade triggers Downgrade triggers are triggers used to ensure more collateral to be posted, if the counterparty is downgraded below a certain level. Fran¸cois CRENIN Credit Risk - Lecture 6

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Counterparty – Introduction

Counterparty risk metrics

WWR and RWR

Counterparty risk mitigations

References

BCBS (2006). Basel II, Annexe 4. BIS. Link. Brigo (2012). Counterparty Risk FAQ. Wiley Finance Book. Link. Brunel and Roger (2015). Le Risque de Cr´ edit : des mod` eles au pilotage de la banque. Economica. Link. Mosconi (2016). Introduction to Counterparty Risk. Bocconi University. Link. Pang et al. (2015). CVA Wrong Way Risk Multiplier Decomposition and Efficient CVA Curve. North Carolina State University. Link. Fran¸cois CRENIN Credit Risk - Lecture 6

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