Counterparty Risk

When one party enters into a financial agreement with another, then the risk that an entity with whom the party has entered into the agreement will fail to honor their part of the bargain is referred to as the counterparty risk. This risk arises from OTC derivatives and securities financial transactions.

Counterparty Risk versus Lending Risk

The following are features of lending risk:

  1. In any given time during the period of lending, the notional amount at risk can be determined with a degree of certainty with only a small level of uncertainty will be created by market variables over the owed amount.
  2. The lending risk is only taken by the bondholder.

Contracts with counterparty risk can be distinguished from traditional credit risk by the following two aspects:

  1. Uncertainties in the future values of contracts, i.e., whether positive or negative as seen from the current day the values of the future will be highly uncertain.
  2. Bilateral counterparty risk as values of the contract can be either positive or negative.

Settlement and Pre-Settlement Risk

A number of settlements equivalent to the total transactions number is contained in a derivatives portfolio. The risk of default by a counterparty before the transaction’s final settlement is known as pre-settlement risk and is mainly associated with counterparty risk. On the other hand, settlement risk is the risk of defaulting due to timing differences when obligations are fulfilled as per the contract.

In the FX market, the settlement contract entails paying with one currency against receiving in a different one.

Mitigating Counterparty risk

Since no risk mitigation strategy is perfect, some residual counterparty risk, whose quantification may be sophisticated and subjective, will always be experienced. Instead of removing counterparty risk, risk mitigants usually convert the risk intro other financial risks forms such as: netting, collateral, hedging, central counterparties, and other contractual clauses.

In addition to reducing counterparty risk that exists and improving the stability of financial markets, counterparty risk mitigation will lead to constraints reduction and consequently a rise in volumes.

X-value adjustment (xVA) is another better way to view the conversion of risk. Some examples are:

  1. Collateral: Since collateral posting needs to be funded, and optionality inherent in the collateral agreement, funding valuation adjustments (FVAs) and collateral valuation adjustments (colVAs) are created.
  2. Termination clauses: Due to regulatory requirements on liquidity buffers, market value adjustments (MVAs) created by early termination events has been exasperated.
  3. Hedging: Rise in capital valuation adjustments (KVAs) is due to additional capital requirements created by credit value adjustments (CVAs) hedging for purposes of accounting.
  4. Central clearing and bilateral rules.

This, therefore, explains the importance of managing xVA centrally and consistent decisions being made regarding risk mitigation, valuation, and pricing for aspects like capital utilization to be optimized and overall economic benefit to be achieved to a maximum level.

Exposure and Type of Product

The exposure of derivatives products is substantially lower as compared to that of an equivalent loan or bond. For instance, an interest rate swap is a contract involving the exchange of floating against fixed coupons and, due to strict exchanges of cash flows, it lacks principal risk.

Moreover, the difference in fixed and floating coupons is the only thing that will be exchanged at coupon dates, thus making coupons not to be fully at risk. Therefore, the comparison between actual derivatives’ total market and total outstanding notional amount is significantly reduced.

Setups

Counterparty risk and its related aspects arise in two situations with the most obvious applying to an end user using OTC derivatives for the purposes of hedging. The general aim of the overall portfolio is offsetting economic exposures elsewhere thus making it typically directional. Consequently, there will be significant mark-to-market (MTM) volatility causing a substantial variation in any associated collateral flows.

Directional portfolios also lead to the availability of reduced netting benefits. The hedging of risks by end-users is on a one-for-one basis. Since the terms quoted by original counterparties may be unfavorable, unwinding transactions will be problematic for end users.

Based on market risk, banks aim at running a hedged book, implying that a client’s transaction will be hedged with a different market participant, causing a series of hedges via the interbank market ending with another opposite exposure to another end user.

The uncollateralization of client’s transactions while collateralizing hedges is another crucial characteristic of the above situation as the existence of counterparty risk problems is based on collateralized transactions despite material risk on hedges being present.

Components

Market-to-Market (MTM) and Cost of Replacement

Analyzing counterparty risk and its associated aspects begin with a mark-to-market (MTM) which is the present value of all payments expected to be received by a counterparty minus the ones supposed to be made. Based on the magnitude of the current market rates and remaining payments, MTM will be positive or negative.

In case of a default, MTM based on a particular counterparty is directly related to what may be lost today by defining the net value of all positions. Transactions’ contractual features (e.g., close-out netting or termination features) refer to cost of replacement which is related to MTM closely and defines the entry point into an equivalent transaction with another counterparty.

In the event of a default, replacement costs are generally referenced by contractual agreements when the surviving party’s position is defined. Since today’s xVA cannot be defined without the future xVA being known, replacement costs will naturally add credit value adjustment (CVA) components creating a recursive problem.

Credit Exposure

In a default scenario by a counterparty, the loss is defined by credit exposure which also represents other costs appearing in other xVA terms. Contrary to a positive value in the portfolio representing a defaulted counterparty’s claim, a negative value event implies an obligation by a party to honor its contractual part.

A default by counterparty can be any time in the future, therefore, making exposure to be time-sensitive, hence the need to consider the event a long time from now. In a default scenario, the recovery value will be ignored by all computations of exposure.

Assuming no recovery value, the loss incurred is the exposure, as defined by the value or cost of replacement. On counterparty default, exposure quantification would be conditional since the relevance of exposure is based on the event of default by the counterparty.

Default Probability, Credit Spreads and Credit Migration

Since the term structure of default likelihood is influenced by the credit quality’s discrete changes or credit migrations, the discrete changes in credit quality are important and should also be considered as concerns might be brought up by them prior to default by the counterparty.

The following are crucial features to be considered:

  1. As the chance of default may occur prior to the considered period, the tendency of default likelihood in the future will be to decrease;
  2. The increasing likelihood of default over time by a counterparty expecting deterioration the quality of credit; and
  3. The decreasing likelihood of default over time by a counterparty expecting improvement in the quality of default.

Based on the historical changes in credit ratings, credit quality has an empirical mean reversion that is popular hence the deterioration in credit quality and vice versa. The definition of the likelihood of default may be as risk-world or risk-neutral which in recent years have become virtually a must when computing CVA.

Recovery and Loss Given Default (LGD)

In the event of default by a counterparty, the percentage recovered of outstanding claim is represented by recovery rates. On the other hand, LGD is 100% less the recovery rate and it is highly uncertain due to the significant variation in default claims.

In bankruptcy scenarios, there will be a pari-passu scenario (similar seniority hence similar recovery value) between OTC derivatives contracts holders with the defaulting counterparty and the senior bondholders.

Control and Quantification

Depending on aspects like transaction and counterparty in question, there is substantial variation in controlling and quantifying counterparty risk. Most banks have been using credit limits as a traditional tool to control counterparty risk. CVA correctly quantifies and ensures accurate compensation of a party for the taken counterparty risk as credit limits only cap counterparty risk.

Credit Limits

The basic principle of credit limits is diversifying counterparty risk by limiting exposure to any given counterparty, broadly in line with the counterparty’s perceived likelihood of default. The potential future exposure (PFE) over time to a counterparty characterizes the idea of credit limits being generally specified at the level of the counterparty.

Since a counterparty’s credit quality has a chance of deteriorating in long periods of time, the reduction in credit limits will often favor short-term over long-term exposures. Trading activity on a dynamic basis is typically assessed by credit limits.

The first step in managing portfolio counterparty risk is represented by credit limits, which are rather binary in nature, allowing a consolidated view of exposure with each of the counterparty.

Credit Value Adjustment (CVA)

Since credit limits work in a binary fashion, the only consideration is the risk of a new transaction, therefore posing a problem as the profit should also be factored in. CVA is a counterparty level calculation and should be incrementally computed by considering exposure changes, accounting for netting effects as a result of any trades existing with the counterparty.

CVA and Credit Limits

The following are the levels to assess a transaction’s counterparty risk: trade level, counterparty level, and portfolio level. At trade and counterparty level, the focus of CVA is evaluating counterparty risk.

To avoid concentrations, credit limits will, in contrast, act at the portfolio level by limiting exposures. To maximize the benefits of netting, the number of trading counterparties should be minimized as suggested by CVA. On the other hand, to encourage smaller exposures, it is the suggestion of credit limits to maximize the said number.

What Does CVA Represent?

A financial product’s price represents future cash-flows expected value, while some adjustments for the taken risks are being incorporated. This price is called the actuarial price. The risk-neutral price is the cost of an associated hedging strategy.

The derivatives to which risk-neutral pricing is standards are always associated with CVA and the CVA can be hedged in various ways. Moreover, CVA can fit into an actuarial perspective due to the liquidity in the credit risk defining CVA.

Recently, dominance in the risk-neutral approach to CVA has been more prominent due to: market practice, accounting, Basel III capital rules, and regulators’ opinions. This has, therefore, made it increasingly uncommon for historical default probabilities to be applied when computing CVA.

Beyond CVA

The following economic aspects are relevant additions to the obvious counterparty risk challenges:

  1. Funding of post collateral amount on the hedge and any initial margin posted is necessary.
  2. For the negative MTM to be collateralized, the chosen cash currency and securities type can be used.
  3. Since capital is a cost, there will be capital specifications and these will change since there will be an increment in capital for the uncollateralized transaction as it becomes in the money.

The xVA Terms

For xVA to be calculated, integration of the indicated profile against the relevant cost or benefit like collateral, credit spread, funding, and many more, has to be affected. The following definitions are from a variety of xVA terms:

  1. The bilateral valuation of counterparty risk is defined by the credit value adjustment (CVA) and debt value adjustment (DVA). The counterparty risk based on the point of view of a party is represented by DVA.
  2. When transactions are funded, the cost and benefits arising are defined by the funding value adjustment (FVA).
  3. In collateral agreements and any non-standard collateral terms, the costs and benefits of embedded optionality are defined by the collateral valuation adjustment (colVA).
  4. The cost at which capital is held over the transaction’s lifetime is defined by the capital valuation adjustments(KVA).
  5. Market value adjustment (MVA) defines the cost of holding an initial margin over the lifetime of a transaction.

Practice Questions

1) Netting is an example of how counterparty risk can be converted into other forms of financial risks. Which of the following best depicts this scenario?

  1. Netting specifies the contractual posting of cash or securities against MTM losses, therefore, creating operational risk and market risks due to the necessary logistics involved
  2. Netting agreements allow offsetting of cash flows and a combination of MTM values into a single net amount in case of default, thereby creating legal risks
  3. By periodically resetting MTM values and early termination of transactions, netting will create operational and liquidity risks because of other termination events
  4. All the above are correct.

The correct answer is B.

By allowing offsetting of cash flows and a combination of MTM values into one net amount, counterparty risk is transformed into legal risk where legal enforcing of netting contract in a particular jurisdiction is impossible.

2) The cost at which capital is held over the transaction’s lifetime is defined the:

  1. Collateral valuation adjustment (colVA)
  2. Capital valuation adjustment (KVA)
  3. Market value adjustment (MVA)
  4. Funding value adjustment (FVA).

The correct answer is B.

All of the options are valuation adjustments made to the value of a portfolio of derivatives to account for credit risks and funding costs. The KVA is the value adjustment for regulatory capital through the life of the contract.


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