Credit Risk

Credit Exposure Methodology Inflation Derivatives

Alan — Tue, 09 Feb 2010 19:57:27 GMT

Current revision posted to Credit Risk by Alan on 09/02/2010 19:57:27

1. Definitions used

*Adj*	Adjusted	Seasonally adjusted, the cyclical variation between months within a year has been removed.
*CPI*	Inflation Index	A government published statistical index, based on 100 at some past point in time and referring to the relative price of a defined basket of goods and services for the currency.
*LFD*	LFD, Last Fixing Date	The last actual historical value of an inflation index before the value date
lag	Lag	Difference in time period used for inflation traded products payoff calculations from value date (usually 2 or 3 months)
*Month()*	Month()	Calendar month function to yield calendar month from date.
*PFE*	PFE	Potential future exposure
*REF*	Reference	Reference index used for future index calculation
<?xml:namespace prefix = o /><o:p> </o:p>	(Inflation)	Payoff for inflation is based on the ratio of two inflation indices.
t₀	Value date	The as-of date for which curves are generated and values generated.

2. Summary

2.1 This document provides a description of the modelling and validation process for inflation linked products, including inflation-linked bonds, inflation swaps, and excluding inflation caps/floors. The general approach to pricing, scenario generation and PFE calculation models and their validation is included, along with the specific tests and results for the inflation products.

3. Modelling Approach

3.1 Specify the inflation products and the pricing models to be used for them. Validate that the models provide adequate valuation and performance on a deal (stand-alone) basis.

3.2 Identify the market data needed and specify a simulation model that will be used to generate scenario data. Validate that the scenarios generated are reasonable

3.3 Use scenario market data and the pricing models to compute potential future exposure and validate the output for the combined system.

3.4 Integrate the calculation of the market scenarios and PFE computation into the IT systems and test end-to-end.

3.5 User acceptance test that the system performs at a level fit-for-purpose for the business.

4. Product Scope

4.1 The products are validated for each currency and country economy (inflation rate or index). The initial validation will include the following:

Inflation-linked bond
Inflation zero coupon swap
Inflation year-on-year swap

Exposure Measurement Key Performance Indicators (KPIs)

Alan — Thu, 12 Nov 2009 19:14:18 GMT

Current revision posted to Credit Risk by Alan on 12/11/2009 19:14:18

Exposure Measurement Key Performance Indicators (KPIs)

Filed under: Exposure Measurement, Credit Risk, Key Performance Indicators, KPIs

One of the concerns senior have understanding at a high level the accuracy of the new credit risk measure during an overhaul of the Risk Frame work or a re-engineering. Model/System changes can hugely impact counterparty risk profiles using the same trade and market data.

Uniting testing of the risk system requires different stages of quality assessment from the market data to the exposure simulation profile.

Risk Factor scenarios, how do these fit with market expectation?
Market to Markets, how does they compare with the equivalent pricer in the trading system?
New Exposure profile profile after upgrade versus current methodology?

If you do not high quality intermediate results which provide sufficient validation metrics for the above then your upgrade or implementation will fail.

Exposure Measurement Key Performance Indicators (KPIs)

Alan — Thu, 12 Nov 2009 19:08:49 GMT

Revision 2 posted to Credit Risk by Alan on 12/11/2009 19:08:49

Exposure Measurement Key Performance Indicators (KPIs)

Filed under: Exposure Measurement, Credit Risk, Key Performance Indicators, KPIs

Uniting testing of the risk system requires different stages of quality assessment from the market data to the exposure simulation profile.

Risk Factor scenarios, how do these fit with market expectation?
Market to Markets, how does they compare with the equivalent pricer in the trading system?
New Exposure profile profile after upgrade versus current methodology?

Exposure Measurement Key Performance Indicators (KPIs)

Alan — Fri, 24 Apr 2009 18:31:28 GMT

Revision 1 posted to Credit Risk by Alan on 24/04/2009 19:31:28

Credit Valuation Adjustment

Alan — Thu, 12 Nov 2009 15:33:46 GMT

Current revision posted to Credit Risk by Alan on 12/11/2009 15:33:46

Credit Valuation Adjustment

Filed under: Credit Value Adjustment, CVA

Credit value adjustment (CVA) is by definition the difference between the risk-free portfolio value and the true portfolio value that takes into account the possibility of a counterparty’s default. In other words, CVA is the market value of counterparty credit risk.

Unilateral CVA is given by the risk-neutral expectation of the discounted loss. The risk-neutral expectation
can be written as

where T is the maturity of the longest transaction in the portfolio, B(t) is the future value of one unit of the base currency invested today at the prevailing interest rate for maturity t ,1{.} is the indicator function that takes value one if the argument is true (and zero otherwise) and PD(s,t) is the risk neutral probability of counterparty default between times s and t. These probabilities can be obtained from the term structure of credit-default swap
(CDS) spreads.

Exposure, Independent of Counterparty Default

Assuming independence between exposure and counterparty’s credit quality greatly simplifies the analysis. Under this assumption this simplifies to

where

which is the risk-neutral discounted expected exposure (EE)

The Function of the CVA Desk and Implications for Technology Solution

In the view of leading investment banks, CVA is essentially an activity carried out by a trading desk in the Front Office. Tier 1 banks either already generate counterparty EPE and ENE under the ownership of the CVA desk (although this often has another name) or plan to do so. Whilst a CVA platform is based on an exposure measurement platform, the solution drivers are very different and it is unwise to create dependencies between the Risk exposure management system and Front Office CVA system, even if they share similar intermediate outputs.

CVA Operating Model

The originating desks for the OTC trades essentially buy their credit protection from the CVA desk. The credit risk of these desks is thus consolidated into a single book, with the net risk of that book hedged by the CVA desk with the rest of the market.

- The key considerations for a Front Office CVA desk are:

Charge Model
Hedging Portfolio CVA
Proxy Hedging
Hedge Effectiveness
P&L Attribution/Revaluation of Portfolio

References

1. A Guide to Modeling Counterparty Credit Risk, GARP Risk Review, July/August 200, Steven H. Zhu, Michael Pykhtin.

2. EM RISK, Risk Analytics (Credit Value Valuation Adjustment Solution Consultants)

Credit Valuation Adjustment

Alan — Thu, 12 Nov 2009 15:33:19 GMT

Revision 15 posted to Credit Risk by Alan on 12/11/2009 15:33:19

Credit Valuation Adjustment

Filed under: Credit Value Adjustment, CVA

Unilateral CVA is given by the risk-neutral expectation of the discounted loss. The risk-neutral expectation
can be written as

Exposure, Independent of Counterparty Default

Assuming independence between exposure and counterparty’s credit quality greatly simplifies the analysis. Under this assumption this simplifies to

where

which is the risk-neutral discounted expected exposure (EE)

The Function of the CVA Desk and Implications for Technology Solution

CVA Operating Model

- The key considerations for a Front Office CVA desk are:

Charge Model
Hedging Portfolio CVA
Proxy Hedging
Hedge Effectiveness
P&L Attribution/Revaluation of Portfolio

References

1. A Guide to Modeling Counterparty Credit Risk, GARP Risk Review, July/August 200, Steven H. Zhu, Michael Pykhtin.

2. EM RISK, Risk Analytics (Credit Value Adjustment Solution Consultants)

Credit Valuation Adjustment

Alan — Thu, 12 Nov 2009 15:14:52 GMT

Revision 14 posted to Credit Risk by Alan on 12/11/2009 15:14:52

Credit Value Valuation AdjustmentDefined

Filed under: Credit Value Adjustment, CVA

Unilateral CVA is given by the risk-neutral expectation of the discounted loss. The risk-neutral expectation
can be written as

Exposure, Independent of Counterparty Default

Assuming independence between exposure and counterparty’s credit quality greatly simplifies the analysis. Under this assumption this simplifies to

where

which is the risk-neutral discounted expected exposure (EE)

References

1. A Guide to Modeling Counterparty Credit Risk, GARP Risk Review, July/August 200, Steven H. Zhu, Michael Pykhtin.

2. EM RISK, Risk Analytics (Credit Value Adjustment Solution Consultants)

Credit Value Adjustment Defined

Alan — Fri, 04 Sep 2009 13:38:23 GMT

Revision 13 posted to Credit Risk by Alan on 04/09/2009 14:38:23

Credit Value Adjustment Defined

Filed under: Credit Value Adjustment, CVA

Unilateral CVA is given by the risk-neutral expectation of the discounted loss. The risk-neutral expectation
can be written as

Exposure, Independent of Counterparty Default

Assuming independence between exposure and counterparty’s credit quality greatly simplifies the analysis. Under this assumption this simplifies to

where

which is the risk-neutral discounted expected exposure (EE)

References

1. A Guide to Modeling Counterparty Credit Risk, GARP Risk Review, July/August 200, Steven H. Zhu, Michael Pykhtin.

2. ADSATIS Risk Consulting EM RISK, Risk Analytics (Credit Value Adjustment Solution Consultants)

Credit Value Adjustment Defined

Alan — Mon, 06 Jul 2009 12:33:21 GMT

Revision 12 posted to Credit Risk by Alan on 06/07/2009 13:33:21

Credit Value Adjustment Defined

Filed under: Credit Value Adjustment, CVA

Unilateral CVA is given by the risk-neutral expectation of the discounted loss. The risk-neutral expectation
can be written as

Exposure, Independent of Counterparty Default

Assuming independence between exposure and counterparty’s credit quality greatly simplifies the analysis. Under this assumption this simplifies to

where

which is the risk-neutral discounted expected exposure (EE)

References

1. A Guide to Modeling Counterparty Credit Risk, GARP Risk Review, July/August 200, Steven H. Zhu, Michael Pykhtin.

2.Parker-Fitzgerald ADSATIS Risk Consulting, Risk Analytics (Credit Value Adjustment Solution Consultants)

Credit Value Adjustment Defined

Alan — Thu, 04 Jun 2009 09:21:52 GMT

Revision 11 posted to Credit Risk by Alan on 04/06/2009 10:21:52

Credit Value Adjustment Defined

Filed under: Credit Value Adjustment, CVA

Unilateral CVA is given by the risk-neutral expectation of the discounted loss. The risk-neutral expectation
can be written as

Exposure, Independent of Counterparty Default

Assuming independence between exposure and counterparty’s credit quality greatly simplifies the analysis. Under this assumption this simplifies to

This assumes for instance that the risk factors for the CDS and

where

which is the underlying are uncorrelated.risk-neutral discounted expected exposure (EE)

References

1. A Guide to Modeling Counterparty Credit Risk, GARP Risk Review, July/August 200, Steven H. Zhu, Michael Pykhtin.

2. Parker-Fitzgerald Consulting, Risk Analytics (Credit Value Adjustment Solution Consultants)

Credit Value Adjustment Defined

Alan — Thu, 04 Jun 2009 08:13:13 GMT

Revision 10 posted to Credit Risk by Alan on 04/06/2009 09:13:13

Credit Value Adjustment Defined

Filed under: Credit Value Adjustment, CVA

Unilateral CVA is given by the risk-neutral expectation of the discounted loss. The risk-neutral expectation
can be written as

Exposure, Independent of Counterparty Default

Assuming independence between exposure and counterparty’s credit quality greatly simplifies the analysis. Under this assumption this simplifies to

This assumes for instance that the risk factors for the CDS and the underlying are uncorrelated.

References

1. A Guide to Modeling Counterparty Credit Risk, GARP Risk Review, July/August 200, Steven H. Zhu, Michael Pykhtin.

2. Parker-Fitzgerald Consulting, Risk Analytics (Credit Value Adjustment Solution Consultants)

Credit Value Adjustment Defined

Alan — Thu, 04 Jun 2009 07:56:59 GMT

Revision 9 posted to Credit Risk by Alan on 04/06/2009 08:56:59

Credit Value Adjustment Defined

Filed under: Credit Value Adjustment, CVA

Unilateral CVA is given by the risk-neutral expectation of the discounted loss. The risk-neutral expectation
can be written as

Exposure, Independent of Counterparty Default

Assuming independence between exposure and counterparty’s credit quality greatly simplifies the analysis. Under this assumption this simplifies to

This assumes for instance that the risk factors for the CDS and the underlying are uncorrelated.

References

1. A Guide to Modeling Counterparty Credit Risk, GARP Risk Review, July/August 200, Steven H. Zhu, Michael Pykhtin.

2. Parker-Fitzgerald Consulting, Risk Analytics (Credit Value Adjustment Solution Consultants)

3. QuiC, Risk Management Software Vendor (CVA Market Leaders)

Credit Value Adjustment Defined

Alan — Mon, 04 May 2009 09:31:46 GMT

Revision 8 posted to Credit Risk by Alan on 04/05/2009 10:31:46

Credit Value Adjustment Defined

Filed under: Credit Value Adjustment, CVA

Unilateral CVA is given by the risk-neutral expectation of the discounted loss. The risk-neutral expectation
can be written as

Exposure, Independent of Counterparty Default

Assuming independence between exposure and counterparty’s credit quality greatly simplifies the analysis. Under this assumption this simplifies to

This assumes for instance that the risk factors for the CDS and the underlying are uncorrelated.

References

1. A Guide to Modeling Counterparty Credit Risk, GARP Risk Review, July/August 200, Steven H. Zhu, Michael Pykhtin.

2. Parker-Fitzgerald Consulting, Risk Analytics (Credit Value Adjustment Solution Consultants)

3. QuiC, Risk Management Software Vendor (CVA Market Leaders)

Credit Value Adjustment Defined

Alan — Mon, 04 May 2009 09:31:46 GMT

Revision 8 posted to Credit Risk by Alan on 04/05/2009 10:31:46

Credit Value Adjustment Defined

Filed under: Credit Value Adjustment, CVA

Unilateral CVA is given by the risk-neutral expectation of the discounted loss. The risk-neutral expectation
can be written as

Exposure, Independent of Counterparty Default

Assuming independence between exposure and counterparty’s credit quality greatly simplifies the analysis. Under this assumption this simplifies to

This assumes for instance that the risk factors for the CDS and the underlying are uncorrelated.

References

1. A Guide to Modeling Counterparty Credit Risk, GARP Risk Review, July/August 200, Steven H. Zhu, Michael Pykhtin.

2. Parker-Fitzgerald Consulting, Risk Analytics (Credit Value Adjustment Solution Consultants)

3. QuiC, Risk Management Software Vendor (CVA Market Leaders)

Credit Value Adjustment Defined

Alan — Mon, 04 May 2009 09:29:57 GMT

Revision 7 posted to Credit Risk by Alan on 04/05/2009 10:29:57

Credit Value Adjustment Defined

Filed under: Credit Value Adjustment, CVA

Unilateral CVA is given by the risk-neutral expectation of the discounted loss. The risk-neutral expectation
can be written as

Exposure, Independent of Counterparty Default

Assuming independence between exposure and counterparty’s credit quality greatly simplifies the analysis. Under this assumption this simplifies to

This assumes for instance that the risk factors for the CDS and the underlying are uncorrelated.

References

1. A Guide to Modeling Counterparty Credit Risk, GARP Risk Review, July/August 200, Steven H. Zhu, Michael Pykhtin.

2. Parker-Fitzgerald Consulting, Risk Analytics (Credit Value Adjustment Solution Consultants)

3. QuiC. Risk Management Software Vendor

Credit Value Adjustment Defined

Alan — Mon, 04 May 2009 09:28:22 GMT

Revision 6 posted to Credit Risk by Alan on 04/05/2009 10:28:22

Credit Value Adjustment Defined

Filed under: Credit Value Adjustment, CVA

Unilateral CVA is given by the risk-neutral expectation of the discounted loss. The risk-neutral expectation
can be written as

Exposure, Independent of Counterparty Default

Assuming independence between exposure and counterparty’s credit quality greatly simplifies the analysis. Under this assumption this simplifies to

This assumes for instance that the risk factors for the CDS and the underlying are uncorrelated.

References

1. A Guide to Modeling Counterparty Credit Risk, GARP Risk Review, July/August 200, Steven H. Zhu, Michael Pykhtin.

2. Parker-Fitzgerald Consulting, Risk Analytics

3. QuiC.

Credit Value Adjustment Defined

Alan — Wed, 22 Apr 2009 11:53:01 GMT

Revision 5 posted to Credit Risk by Alan on 22/04/2009 12:53:01

Credit Value Adjustment Defined

Filed under: Credit Value Adjustment, CVA

Unilateral CVA is given by the risk-neutral expectation of the discounted loss. The risk-neutral expectation
can be written as

Exposure, Independent of Counterparty Default

Assuming independence between exposure and counterparty’s credit quality greatly simplifies the analysis. Under this assumption this simplifies to

This assumes for instance that the risk factors for the CDS and the underlying are uncorrelated.

References

1. A Guide to Modeling Counterparty Credit Risk, GARP Risk Review, July/August 200, Steven H. Zhu, Michael Pykhtin.

Credit Value Adjustment Defined

Alan — Wed, 22 Apr 2009 11:42:24 GMT

Revision 4 posted to Credit Risk by Alan on 22/04/2009 12:42:24

Credit Value Adjustment Defined

Filed under: Credit Value Adjustment, CVA

Credit value adjustment (CVA) is by definition the difference between the risk-free portfolio value and the true portfolio value that takes into account the possibility of a counterparty’s default. In other words, CVA is the market value of counterparty credit risk.

Unilateral CVA is given by the risk-neutral expectation of the discounted loss. The risk-neutral expectation
can be written as

References

1. A Guide to Modeling Counterparty Credit Risk, GARP Risk Review, July/August 200, Steven H. Zhu, Michael Pykhtin.

Credit Value Adjustment Defined

Alan — Wed, 22 Apr 2009 11:38:35 GMT

Revision 3 posted to Credit Risk by Alan on 22/04/2009 12:38:35

Credit Value Adjustment Defined

Filed under: Credit Value Adjustment, CVA

Credit value adjustment (CVA) is by definition the difference between the risk-free portfolio value and the true portfolio value that takes into account the possibility of a counterparty’s counterparty’s default. In other words, CVA is the market value of counterparty credit risk.

References

1. A Guide to Modeling Counterparty Credit Risk, GARP Risk Review, July/August 200, Steven H. Zhu, Michael Pykhtin.

Credit Value Adjustment Defined

Alan — Fri, 10 Apr 2009 08:55:21 GMT

Revision 2 posted to Credit Risk by Alan on 10/04/2009 09:55:21

Credit Value Adjustment Defined

Filed under: Credit Value Adjustment, CVA

References

1. A Guide to Modeling Counterparty Credit Risk, GARP Risk Review, July/August 200, Steven H. Zhu, Michael Pykhtin.

Scenario Generation

Alan — Wed, 22 Apr 2009 12:01:41 GMT

Current revision posted to Credit Risk by Alan on 22/04/2009 13:01:41

Credit Exposure Methodology Equity Derivatives

Alan — Wed, 08 Apr 2009 07:41:24 GMT

Current revision posted to Credit Risk by Alan on 08/04/2009 08:41:24

Credit Exposure Methodology,Equity Derivatives

Measuring and marking counterparty risk

Alan — Fri, 20 Mar 2009 11:28:02 GMT

Current revision posted to Credit Risk by Alan on 20/03/2009 11:28:02

Measuring and marking counterparty risk

Introduction

The volume of outstanding OTC derivatives has grown exponentially over the past 15 years.
Market surveys conducted by the International Swaps and Derivatives Association (ISDA)
show notional amounts of outstanding interest rate and currency swaps reaching US$866 billion
in 1987, US$17.7 trillion in 1995, and US$99.8 trillion in 2002; an astonishing compounded
growth rate of 37.2% per year.1 Derivatives have expanded the opportunities to transfer risks, allowing for substantially improved risk sharing. They have also created connections among markets and market participants that are only just starting to be understood.

Counterparty risk, an example of one such connection, is the risk that a party to an OTC
derivatives contract may fail to perform on its contractual obligations, causing losses to the
other party. Losses are usually quantified in terms of the replacement cost of the defaulted
derivatives and include, beyond mid-market values, the potential market impact of large
and/or illiquid positions. Counterparty risks are bilateral – ie, both parties may face exposures
depending on the value of the positions they hold against each other. Counterparty risks have
mushroomed in the financial markets due to (a) the usual practice of ‘offsetting’ rather than
‘unwinding’ derivative positions and (b) the array of inter-dealer trades required to connect
final risk-takers.

OTC derivatives and counterparty risks are focal points for market participants, policy-
makers, regulators, accountants, tax authorities and many others. This chapter is an overview
of the key issues relating to the measurement and pricing of counterparty risks.

Counterparty exposures

Definitions

Counterparty exposure is the larger of zero and the market value of the portfolio of derivative positions with a counterparty that would be lost if the counterparty were to default and there were zero recovery. Counterparty exposures created by OTC derivatives are usually only a small fraction of the total notional amount of trades with a counterparty.
Current exposure (CE) is the current value of the exposure to a counterparty.
Potential future exposure (PFE) is the maximum amount of exposure expected to occur on
a future date with a high degree of statistical confidence. For example, the 95% PFE is the level of potential exposure that is exceeded with only 5% probability. The curve PFE(t),
as t varies over future dates, is the potential exposure profile, up to the final maturity of
the portfolio of trades with the counterparty. PFE(t) is usually computed through simulation
models: for each future date t, the value of the portfolio of trades with a counterparty
is simulated. A high percentile of the distribution of exposures is selected to represent the
PFE(t). The peak of PFE(t) over the life of the portfolio is referred to as maximum potential
future exposure (MPFE). PFE(t) and MPFE are often compared with credit limits in
the process of permissioning trades.
Expected exposure (EE) is the average exposure on a future date. The curve of EE(t), as t
varies over future dates, provides the expected exposure profile. The expected exposures
are computed with the same models used for PFEs. The EE(t) curve is referred to as the
‘credit-equivalent’ or ‘loan-equivalent’ exposure curve, and is used for credit pricing and
for the calculation of the economic capital of well-diversified portfolios of counterparties.
Expected positive exposure (EPE) is the average EE(t) for t in a certain interval (for example, for t during a given year).
Right-way/wrong-way exposures are exposures that are positively/negatively correlated
with the credit quality of the counterparty. Those exposures may have lower/higher expected credit losses associated with them than would be the case without correlation. A company writing put options on its own stock creates wrong-way exposures for the buyer. An oil producer selling oil in a swap creates right-way exposures for the buyer.
Credit risk mitigants are designed to reduce credit exposures. They include netting rights,
collateral agreements, and early settlement provisions.

Examining these credit risk mitigants in more detail, legally enforceable netting agreements allow trades to be offset when determining the net payable amount upon the default of the counterparty. Without netting, the position of the non-defaulting party would be a loss of the
full value of the out-of-the-money trades against a claim on the total value of the in-themoney trades. With netting, positives and negatives are added first to determine the net payment due. For example, if a counterparty holds a currency option written by its bank with a market value of 50, while the bank has an interest rate swap with the same counterparty Collateral agreements require counterparties to periodically mark to market their positions and to provide collateral (that is, to transfer the ownership of assets) to each other as exposures exceed pre-established thresholds. Usually the threshold schedule is a function of the credit ratings of the counterparties. Counterparties with high/low credit ratings have to post collateral if amounts due exceed high/low thresholds. Collateral agreements do not eliminate all counterparty risks: exposures may exist below the thresholds; market movements can increase the exposure between the time of the last collateral exchange and the time when default is determined and the trades are closed out; the collateral received/posted depreciates/appreciates in value during the close-out period.

Liquidity puts, credit triggers and other early termination provisions reduce credit exposures
by shortening the effective maturities of trades. Liquidity puts give the parties the right
to settle and terminate trades on pre-specified future dates. Credit triggers specify that trades
must be settled if the credit rating of a party falls below pre-specified levels.

Some counterparties trade many financial products (for example, loans, interest rate
swaps, bond repos, foreign exchange options or commodity swaps). The ability to apply
cross-product netting is desirable for the reasons mentioned above. Legal issues on the
enforceability of netting arise when a dealer books trades at various legal entities, possibly
based in different jurisdictions.

PFE models: an overview

Over the last decade, derivatives dealers have invested large amounts of resources to build
sophisticated PFE measurement systems. Those systems comprise:

Databases (trades, agreements, legal entities, legal opinions, collateral holdings, risk limits);
Monte Carlo simulation engines;
Trade pricing calculators;
Exposure calculators; and
Reporting tools.

The estimation of PFEs requires sophisticated models to simulate exposures in market scenarios
on various future dates. The specification of the PFE model and its ongoing validation are of paramount importance. In the following subsections alternative model specifications are discussed, and certain choices and trade-offs are highlighted.

Simulation engine

Different market instruments require the specification of different stochastic processes to
characterize their evolution through time. Interest rates in developed economies are often
modeled as normal or lognormal diffusion processes. When interest rates are low, the normal
diffusion may be more appropriate. When interest rates are high, the lognormal diffusion
may be more appropriate. Many variants are possible. Major foreign exchange rates are usually modeled as lognormal diffusions. This practice is in contrast with the modeling of
emerging market foreign exchange rates, where significant jumps can occur. Jump-diffusion
processes are generally employed to characterize the movements of the prices of emerging
market or pegged currencies. The stochastic processes followed by the emerging market currencies may not be Markovian: the past history of the exchange rates affects the likelihood
of a large devaluation. For example, if a currency has not been devalued for a long period of
time, then it may be more likely to be devalued in the near future. Immediately after a devaluation, the likelihood of another would be reduced. The shorter the time horizons over which PFEs are computed, the larger is the importance of modeling jumps, where required (see Das
and Sundaram, 1999). For longer horizons, the impact of jumps tends to dissipate and the
process cannot be easily distinguished from diffusion. Thus, the modeler must consider the
horizon at which the PFEs are computed. Although commodity and equity prices are usually
modeled as lognormal diffusions, it may be necessary to model jumps for some less liquid
commodities and equities.

Sometimes the risk factor to be simulated is not a single price, but rather a string of prices.
Examples are interest rate curves and commodity forward curves. In these cases, the simulation
model must be sufficiently elaborate to impose the proper arbitrage-free constraints and
realism on the reshapings of the curve. Arbitrage-free, multi-factor, term structure models have
been applied to simulate the evolution of interest rate and commodity curves.

Some prices exhibit mean-reversion. For example, very high and very low interest rates
are unlikely to persist for long periods of time in well-functioning economies. Mean-reversion
is especially important when generating long-dated exposures. If mean-reversion (or
some other form of volatility compression) is not incorporated, then unrealistic levels of
exposures could be estimated at long horizons.

The calibration of the parameters of the simulation models is an important step in
model building. The future values of the market risk factors are fundamentally determined
by the calibration scheme. Models calibrated to historical data tend to project future values
based on the statistical regularities observed in the past. Models calibrated to market prices
(such as forward curves and option-implied volatilities) tend to reflect forward-looking
views. There are positive and negative aspects in each form of calibration. Historical calibration
implies that the process generating future market behavior is the same that was
observed in the past. The model may be slow to react to changes in market conditions and
structure, even if a time-decay factor is used to over-weight more recent observations. On
the other hand, market prices contain components that are not the result of market participants’
expectations about the future (for example, risk premiums, carrying costs, and so
on). The objective of the simulation model is to project as realistically as possible the future
developments in the markets being simulated. In that sense, the models should operate
under the real probability measure. The only justification to use the risk-neutral measure is
that, to some extent, it contains the consensus expectations of market participants on future
prices, volatilities, and so on. When the simulations are used for pricing, the risk-neutral
probabilities have to be used (see the ‘Market valuation of credit exposures’ section later
in this chapter).

The correlations among market risk factors are the most important determinants of the
potential future exposures created by large and well-diversified portfolios of trades.
Positively correlated risk positions tend to increase credit exposures.

Trade pricing

Once a future market scenario is generated, in order to calculate the exposure in that scenario,
all trades with the counterparty must be priced. That task consumes large computational
resources. Imagine a swap dealer’s book with 100,000 positions, with average maturity of
seven years, and 2,000 market scenarios generated every three months. One would need to perform 5.6 billion pricings. At, for example, 100 microseconds per pricing, this would correspond
to 156 hours of CPU time. Clearly, a good amount of financial and software engineering
is required. In the early history of risk measurement, some large dealers retained super-computers for the computation of the credit exposures generated by their portfolios of OTC derivatives. Others developed heavily engineered algorithms to economize on the computation time (incorporating price grids, sophisticated interpolation schemes in both time and space dimensions, and so on). More recently, distributed/parallel processing has been employed.
Unnecessary pricing complexity should be avoided: one should avoid refining within the margin
of error. This is particularly important for long-dated exposures: the volatilities, correlations
and probabilistic assumptions used in constructing the long-dated scenarios are
themselves surrounded by considerable uncertainty. Constructing highly accurate (and computationally intensive) pricing calculators often qualifies as refining within the margin of error.

The collection and integration of market data, trades, agreements, legal and other information
required to compute PFEs demands access to various front- and back-office systems
spread throughout organizations. The level of cooperation among various departments must
be high. Indeed, the data-integration challenge is an important reason used to explain why
various first-tier financial institutions have not succeeded in evolving their PFE models
beyond simplistic add-on rules. In addition, there is a need to develop and implement reporting
tools to deliver the resulting information to various levels of decision makers in a timely
and clear fashion.

Exposure calculation

After all trades with a counterparty have been repriced at a scenario/date, exposures can be
computed. There are two fundamental concepts for the calculation of exposures: netting and
margin nodes. A netting node is a collection of trades that can be netted. A margin node is a
collection of trades whose values should be added in order to determine the collateral to be
posted or received. The portfolio of positions with a single counterparty may comprise multiple
netting and margin nodes. The counterparty exposure is determined by:

Calculating the exposure in each netting node;
Adding all netting node exposures;
Calculating the collateral posted/received for each margin node;
Adding collateral posted/received; and
Calculating the net exposure to the counterparty as (2) minus (4).

The calculation method above, (1)–(5), implies that a counterparty with one netting node, one
coincident margin node, and a zero collateral threshold would generate zero exposure.
Sophisticated PFE models recognize that collateral does not change hands continuously and
instantaneously. These models allow for a period of time between an event causing default and the final closing out of trades. A typical, conservative, close-out period is two weeks.

Model validation and control

All the computer code underlying a PFE model is extensively tested during the implementation
phase, and re-tested on an ongoing basis via regression tests. Code changes are documented,
independently verified and approved before released to production. The inputs to the
model are reconciled with alternative sources of the same information. Counterparty positions
are verified against the official books and records of the firm. The outputs of the model are
verified for reasonableness under many conceivable stress scenarios. Historical, static back-
testing is feasible and sometimes applied. Ongoing, dynamic backtesting is more difficult due
to changes in the positions with each counterparty over time. Credit risk managers (users of
the PFE model) provide valuable feedback on the quality of the output. Over the last decade,
the validation and control requirements on PFE models have evolved to standards comparable
to front-office calculators. This was primarily the result of the use of the outputs of those
models for the market valuation of credit risk and calculation/allocation of economic capital.
Internal and external auditors as well as industry regulators apply rigorous standards in ascertaining
that the implementation and control of a PFE model is sound.

Applications of exposure modeling

The most important uses of PFE models are:

Ttrade approvals against credit line limits;
Credit risk valuation; and
Economic and regulatory capital.

Credit officers set limits on PFE profiles. The limits tend to be wider for short terms and
tighter for long terms. In the process of permissioning new trades, the PFE profile to a counterparty is re-computed including the new trades. The PFE profile is then compared with the
limit schedule. PFE models also generate the inputs for credit risk valuation. When exposures
are uncorrelated with the credit quality of the counterparty, the unconditional expected exposure
profile is used for valuation.

Another application of PFE models is the calculation of economic capital to support the
risk of a portfolio of counterparties. The variability of exposures and the possible concentrations
on certain market risk factors increases the risk of the portfolio. Ideally, a dealer would
compute the economic capital of the portfolio of counterparties by applying a full simulation
model – that is, a model in which market and credit risk variables are simulated simultaneously.
In practice, many dealers tend to use expected exposure profiles, sometimes grossed up
by a multiplicative factor to proxy for the increased risk of variable exposures. Canabarro,
Picoult, and Wilde (2003) have shown that the gross-up factor depends on the characteristics
of the portfolio of counterparties, with typical values in the range 1 to 1.25. That is, for the
purposes of calculating economic capital, expected exposure profiles should be multiplied by
that factor in order to produce results equivalent to full simulation.

Market valuation of credit exposures

The credit valuation adjustment (CVA) of an OTC derivatives portfolio with a given counterparty
is the market value of the credit risk due to any failure to perform on agreements with
that counterparty.2 This adjustment can be either positive or negative, depending on which of
the two counterparties bears the larger burden to the other of exposure and of counterparty
default likelihood.

More generally, the market value of credit risk to a given counterparty incorporates the
valuation of credit risk associated with all positions with that counterparty, including loans to,
and inventories of securities issued by, that counterparty. Accurate pricing of these credit risks
is an important determinant of mark to market earnings, and is the first line of defense in credit
risk management. For example, underestimates of the market valuation of the credit risk
with a given counterparty may bias prices in favor of accumulating larger risks with that
counterparty, and the potential of large hidden losses that may only come to light at unfavorable
events. Thus, in order to provide proper incentives to traders, the pricing of counterparty
credit risk should be accurate. Some banks have set up internal credit risk trading desks
charged with responsibility for pricing, hedging, and bearing the credit risk components of all
counterparty positions.

In practice, it is typical to view the credit adjustment on the portfolio of positions with a
given counterparty as an adjustment to the mid-market valuation of that portfolio. For example,
consider an off-market yen–U.S. dollar currency swap between A, the yen receiver, and B. Suppose the mid-market valuation of the swap to the yen receiver is 100. Suppose this
mid-market valuation already includes an effective market value of two for default risk to the
hypothetical yen receiver, net of the market value of the default risk to the hypothetical yen
payer. Suppose the actual swap between A and B has a net market value of default risk to A
of five, because the yen payer happens to be of lower than mid-market quality. Then the credit-
risk adjustment is a downward adjustment of three, leaving a fair market value to A of 97.
In many cases, however, the default risk portion of the mid-market valuation is small and
ignored, causing the credit adjustment to mid-market valuation to coincide with the total measured market value of the credit risk of the OTC position. Mid-market valuations of at-market interest rate swaps, for example, are based on hypothetical counterparties of equal and high (say, AA) quality, so the effects of default risk are essentially offsetting. They need not be precisely offsetting, as the fixed-rate payer has slightly different expected exposures than the floating-rate payer. For example, in an upward-sloping yield curve environment, we expect the exposure to the floating-rate receiver to grow over time, as the floating rate is expected to grow, in a risk-neutral sense. Even so, on a plain-vanilla U.S. dollar interest rate swap between AA counterparties, the net market value of counter-party default risk associated with mid-market valuations is often indeed negligible. This may not be the case for other OTC positions, especially those with large expected exposures to only one of the two counterparties, such as long-dated options and off-market swaps.

Risk premiums

Investors demand a reward for bearing risk. The reduction in market value of an OTC position
due to the counterparty’s credit risk is typically larger than the actuarial expected loss,
discounted to present value. For example, suppose a short-term bond promising US$100,000
will default with an actual probability of 30%, and in the event of default, half of the value is lost. The actual default probability might be estimated, for example, by the Moody’s-KMV
EDF measure (see Kealhofer, 2003). The mean loss rate is therefore 15%, the product of the
loss probability with the fraction lost given default. We will ignore the time value of money
for this example, taking interest rates to be zero. Given the mean loss rate of 15%, the expected
payoff of the bond is 85,000. Investors, however, would typically pay less than 85,000 for
this defaultable bond. In order to give an investor an incentive to buy this risky bond rather
than a default-free bond with a payoff of 85,000, the market price of the defaultable bond
must normally be something less than its expected payoff. For example, the defaultable bond
may have a market price of 80,000. This means that, for pricing and trading purposes, bond
investors may act as though they are neutral to risk, but assign an artificially high mean loss
rate of 20%. In this sense, 20% is called the ‘risk-neutral mean loss rate’. The risk-neutral
mean loss rate is a key input to bond pricing and other credit risk pricing applications.

In practice, one could estimate the risk-neutral mean loss rate on a bond, or some other
exposure such as a swap, from the prices of corporate bonds issued by the same or similar
firms. Corporate bond prices reflect the probability of default in the same risk-neutral sense.
Annualized risk-neutral mean loss rates, on average over the life of an exposure, are roughly
the same as the counterparty’s credit spread – that is, the portion of the counterparty’s bond
yields that is due to credit risk. For example, suppose that a bond yield is 8%, but would have
been 7.5% were it not for the risk of its default. Then the average risk-neutral mean loss rate
is roughly 50 bps. One should not estimate the yield spread associated with credit risk by taking
the difference between the corporate bond yield and the yield of a Treasury bond of the
same maturity, say 7%, for the Treasury yield is depressed from corporate bond yields by
other important factors, notably the state tax exemption for U.S. Treasury coupon income,
and the superior liquidity of Treasuries. Recently, default swaps, a class of credit derivatives,
have become an important source of information regarding risk-neutral mean loss rates. A
default swap obligates the counterparty buying default protection to pay the default swap rate
at periodic coupon dates until maturity or default of the underlying ‘insured’ bond or loan,
whichever arrives first. If and when default arrives first, the seller of protection effectively
pays the buyer of protection the difference between the face value and the market value of the
underlying bond or loan.3 The default swap rate for a particular corporate bond is approximately
equal to the average risk-neutral mean loss rate on the underlying bond.

OTC derivatives such as swaps may have systematically different fractions of exposure
lost at default than corporate bonds, although there is not much evidence available on this
point. One must use reasonable modeling assumptions.

Mean* exposure times mean* loss rate

A typical method for bilateral credit adjustments when only one of the two counterparties has
a credit exposure is to compute the market value of the credit risk by adding up the discounted
risk-neutral mean default loss, period by period, over the life of the positions between these
two counterparties. (Discussion of two-sided default risk, which arises, for example, with
interest rate swaps, is deferred until later.)

The total market value V(t) of default risk during the t-th future time period (say, a future
calendar quarter) is computed by the following steps.

Calculate EE*(t), the risk-neutral expected exposure for period t, that is, the average of
exposures weighted by their risk-neutral probabilities, over all possible scenarios. (The
distinction between risk-neutral and actual expectations is emphasized with an asterisk.)
This is the risk-neutral expected market value that would be lost with default during that
period, with no recovery, given the effect of all applicable netting, collateral, and other
credit enhancements. This exposure measure, EE*(t), can be calculated, for example, from
derivative pricing algorithms. The risk-neutral expected exposure EE*(t) may in some
cases be significantly different than the expected exposure uncorrected for risk premiums,
and this certainly seems to be the case with U.S. Libor interest rate swaps.
Calculate the risk-neutral mean default loss rate L*(t) associated with the period, which is
the product of the risk-neutral likelihood of default during the period and the risk-neutral mean fraction of exposure lost in the event of default.
Obtain C(t), the price of a default-free zero-coupon bond of maturity t.
Calculate V(t) = EE*(t) × L*(t) × C(t). This calculation of V(t) ignores the effect of correlation between exposure and interest rates. To correct for this, one could calculate the expected exposure EE*(t) under forward risk-neutral probabilities.
Additional adjustments for correlation due to wrong-way or right-way exposure effects can sometimes be substantial. For example, a wrong-way increase in risk-neutral mean loss rates of 40 bps per 100-bp change in Libor could double the credit-risk adjustment on an interest rate swap (see Duffie and Huang, 1996). The total market value of the credit risk is V(1) + V(2) +…+ V(T), where T is the final time period of exposure to that counterparty.

This risk-neutral mean-discounted loss calculation of credit risk market value adjustments
is reasonable in many cases. By the early 1990s, credit risk adjustments of the above
variety had been developed for interest rate swaps by Sorensen and Bollier.6

General Monte Carlo approach

Risk-neutral Monte Carlo simulation can be used to obtain an estimate of the market value of
credit risk in bilateral OTC portfolios, allowing for default by either counterparty, for general
types of derivatives and other positions such as loans and options, for netting and collateral
agreements, and for correlation between default risk and changes in underlying market
prices and interest rates.

The general approach is to begin by calculating the market value V(B) of all future potential
losses to a particular Party A due to default by Counterparty B. The same algorithm can
likewise be used to calculate the market value V(A) of losses to Counterparty B through
default by Counterparty A. The difference V(B)–V(A) is the net market value of the default
losses to Counterparty A.

The algorithm is described in simple illustrative terms, and not in a complete and computationally
efficient manner, as follows.

Initiate a new, independently simulated scenario.
2.
Simulate, for this scenario, date by date, the net exposure of Counterparty A to default by
Counterparty B. At each date, this gives the market value that would be lost if B were to
default at that date, with no recovery, with all applicable netting agreements in force, and
net of all collateral. The enforceability of netting and the valuation of collateral can also be simulated if uncertain.

3.
Simulate, date by date, whether or not B defaults at that date, and whether A defaults at
that date.
4.
If, at a given date, Counterparty B defaults and Counterparty A has not already defaulted,
then simulate the fraction of the net exposure, as obtained in Step 2, that is lost. This determines the losses to A in this scenario.
5.
Simulate the path of short-term interest rates.
6.
Discount to present market value, using the compounded short-term interest rates for this
scenario, the losses to Counterparty A.
7.
Return to Step 1, unless a sufficiently large number of scenarios have been run to obtain
the approximate effect of the law of large numbers.
8.
Average the results of Step 6, over all independently generated scenarios. This average is
the estimate of the market value of default losses to Counterparty A due to default by
Counterparty B. The net total market value of the default risk to Counterparty A is V(B)–V(A), the market value of default losses to Counterparty A that are due to default by Counterparty B, as above, net of the market value V(A) of the losses to Counterparty B due to default by Counterparty A. This difference V(B)–V(A) can be positive or negative.

Example

For a simple example, we present the net present value of default losses to Counterparty A,
the payer on a plain-vanilla interest rate swap, and Counterparty B, the receiver. The swap
is a 10-year (semi-annual coupon) U.S. dollar Libor swap with a fixed rate of 7.6% that
would be at-market for this example if the counterparties were default-free. The notional
amount of the swap is 1,000,000. The column of Exhibit 9.2 labeled ‘PV(X)’ shows the estimated
present value (in hundreds) of the exposure to the payer in the event of default by the
receiver, based on a three-factor affine term structure model, fit to historical Libor swap and
swaption rates during the 1990s, as described in Chapter 12 of Duffie and Singleton (2003),
upon which this example is based. This is the same as the price of the payer swaption, to
enter a swap at a fixed rate of 7.6%, the indicated coupon date t with maturity 10-t years
later. The volatilities of the model are set to match the volatility of the six-month-into-twoyear
at-market swaption at 16.5%. The column of Exhibit 9.2 labeled ‘PV(Y)’ shows the
present value of the exposure to the receiver (which is the same as the market value of the
corresponding receiver swaption). Note that, despite the fact that the swap rate is the at-market
rate (for default-free counterparties) and the present values of the exposures to the two
counterparties are thus similar, they are not the same. Indeed, although the two counterparties
are assumed to be of equal credit quality, each having a credit spread of 50 bps and the
same risk-neutral mean fraction 50% of loss given default, we shall see that the net present
value of default losses to the payer is positive, while the net present value of default losses
to the receiver is negative.

A flat term structure of credit spreads of 50 bps and a 50% risk-neutral mean fraction lost
given default implies a constant risk-neutral default intensity of 100 bps for each counterparty.
We will assume for simplicity that they default independently of each other and of changes
in interest rates. As indicated in the algorithm above, in order to price the default losses to the

PART III: ADVANCES IN ASSET/LIABILITY MANAGEMENT

Exhibit 9.2
Example of mark-to-market for default on swap
Coupon date t
PV(X)
(100s)
PV(Y) Loss rate
(bp)
PVLR PVLP
0.5
1
1.5
2
Years 2.5–9 omitted
9.5
167
216
243
256
25
217
288
327
348
34
24.9
24.6
24.4
24.1
20.8
53.9
70.9
79.7
84.0
7.0
41.4
53.2
59.2
61.9
5.2
Total
Credit adjustment
1,079.6
289.0
790.6
–289.0
Source: Based on results from Duffie and Singleton (2003).

payer at a given coupon date t associated with first default by the receiver at that date, we
want the probability p(t) of this event. It can be shown (see Duffie and Singleton, 2003) that
the loss rate for each coupon date t, which is p(t) times the 50% mean loss given default, is
as shown in Exhibit 9.2, in basis points. These loss rates are the same for payer and receiver
given the symmetry of credit qualities.

Now, we can calculate the present value PVLP = PV(X) × (loss rate) of the default loss
to the payer due to first default by the receiver at coupon date t, as shown in the last column
of Exhibit 9.2, and likewise the present value PVLR = PV(Y) × (loss rate) of the default loss
to the receiver due to first default by the payer at that date. Adding these over all coupon dates
(some of which, for brevity, are not shown in Exhibit 9.2) leaves the total present value of
default losses to the receiver due to first default by the payer of US$1,080. Similarly, the total
present value of default losses to the payer due to first default by the receiver is US$791. The
net reduction in market value to the receiver due to default losses is 1,080 – 791 = US$289.
There is a net upward credit adjustment for the payer of US$289. Because the swap rate is at-
market for default-free counterparties, the mark to market value of the swap for the payer is
also US$289 (positive).

General remarks on credit adjustments

There is some scope for reasonable variation in the computation of the market value of default
losses, even among models that have the same conceptual foundations and intent. These differences
can arise from reasonable but different inputs (such as risk-neutral mean loss rates)
and also from different model structures. This is an active area of research and development.

In many cases, a downward adjustment from mid-market value is appropriate. Upward
credit adjustments can also be appropriate, whether or not the counterparty is of higher credit
quality than the broker-dealer. In general, the higher the relative quality of the counterparty,
the greater is the fair market value of a given derivative to the dealer (an obvious point).

For example, consider an interest rate swap between an outside customer Z, and one of
two possible dealers, Gilt, rated AAA, and Silver, rated BBB. Suppose that Z, rated AA,

MEASURING AND MARKING COUNTERPARTY RISK

wishes to pay the floating rate, and first calls Gilt, receiving a quote R for the fixed rate to be
paid by Gilt, set so that there is no initial exchange of cash, meaning that the fair market value
of this swap between Z and Gilt is zero.

Now, suppose Z calls the lower-quality dealer Silver in order to obtain an interest rate
swap under which Z pays floating and Silver pays the same fixed rate R. They negotiate an
upfront price P to be paid by Silver that is greater than zero because Z was willing to receive
a price of zero under the same contractual terms when trading with the higher-quality dealer,
Gilt. Thus, Z should demand some positive price P in compensation for bearing the comparably
higher credit risk of Silver. This means that an upward adjustment in the market value
of the swap to Silver, relative to the price of zero obtained by Gilt. Even holding constant the
credit qualities of counterparties, the credit risk adjustment can change sign as changes in
market prices reverse the direction of exposure.

When dealers (and other firms) issue bonds, they sell them to investors at a price that
reflects their own credit quality. The lower their quality, the lower the price at which they are
willing to issue their bonds, relative to those issued by higher-quality firms. The same principle
applies to derivatives.

Conclusion

In this chapter, we have discussed techniques that are currently used to measure and price
counterparty risks. This is a rapidly evolving area of risk management. The phenomenal
expansion of the credit derivatives markets, together with the maturation of techniques used
to price and hedge counterparty risks, has caused a fundamental change in the perception and
management of those risks. ‘Liquid’ counterparty risks are now hedgeable, and should be
managed and assessed in the same manner as other hedgeable risks.

The traditional potential-exposure framework discussed in the first part of this chapter
takes a static buy-and-hold view of counterparty risks, without incorporating the possibility of
dynamic hedging of liquid credit risks. As the liquidity and completeness of the credit derivatives
market continues to grow, more and more counterparty risks will become hedgeable.
Static potential exposure measures will be superseded by Value-at-Risk (VaR) and stress limits
similar to those currently used for other liquid market risks (such as those inherent in interest
rates and currencies). Some firms have adopted internal credit risk hedging via desks whose
purpose is to provide credit protection, at a transfer price, to other desks within the firm and
then to choose how much of the firm’s net exposure to each counterparty is to be traded to outside counterparties. More decentralized firms have desk-by-desk hedging of credit risks.

These developments will have a fundamental impact in the asset and liability management
of financial institutions that deal in derivatives. A large part of the counterparty risk of
these institutions will be transferred via dynamic hedging, hopefully improving the risk sharing
among many economic agents and increasing market efficiency.

It seems crucial that regulators appreciate this transformation. In particular, the framework
used to assess counterparty risk should evolve pari passu with the possibilities of risk
management.

The process of transformation of the static, buy-and-hold perception of counterparty risk
into dynamic hedging programs is irreversible.

Bibliography

Canabarro, E., E. Picoult, and T. Wilde (2003), ‘Analysing counterparty risk’, Risk Magazine,
Vol. 16, No. 19, pp. 117–122 (September).

Das, S., and R. Sundaram (1999), ‘Of Smiles and Smirks, A Term Structure Perspective’,
Journal of Financial and Quantitative Analysis, Vol. 34, pp. 211–239.

Duffie, D. (1999), ‘Credit swap valuation’, Financial Analysts Journal, January–February,
1999, pp. 73–87.

Duffie, D., and M. Huang (1996), ‘Swap rates and credit quality’, Journal of Finance, Vol.
51, pp. 921–949.

Duffie, D., and K. Singleton (2003), Credit Risk, Princeton, Princeton University Press.

Hull, J. (2000), Options, Futures, and Other Derivative Securities, 4th edition, Englewood
Cliffs, NJ, Prentice-Hall.

Kealhofer, S. (2003), ‘Quantifying credit risk I: Default prediction’, Financial Analysts
Journal, January–February, pp. 30–44.

1
See published surveys on ISDA’s website, www.isda.org.

2
This section includes excerpts from ‘Expert Report of Darrell Duffie’, United States Tax Court, Bank One
Corporation, Versus Commissioner of Internal Revenue, Docket Numbers 5759-95, 5956-97. See also, ‘Decision
of The Court, 2 May 2003’.

3 For details and variants, see Duffie (1999).
4 For a numerical example, see Duffie and Singleton (2003), Chapter 12.
5 For an introduction to forward-risk-neutral calculations, see, for example, Hull (2000).
6 The work of Sorensen and Bollier appeared in Financial Analysts Journal, May–June 1994, pp. 23–33.

References

Eduardo Canabarro; Head of Credit Quantitative Risk Modeling, Goldman Sachs
Darrell Duffie; Professor, Stanford University Graduate School of Business
[[credit_risk:Asset/Liability Management of Financial Insitutions|Asset/Liability Management of Financial Insitutions]]

Measuring and marking counterparty risk

Alan — Fri, 20 Mar 2009 11:23:59 GMT

Revision 6 posted to Credit Risk by Alan on 20/03/2009 11:23:59

Measuring and marking counterparty risk

Introduction

Counterparty exposures

Definitions

Counterparty exposure is the larger of zero and the market value of the portfolio of derivative positions with a counterparty that would be lost if the counterparty were to default and there were zero recovery. Counterparty exposures created by OTC derivatives are usually only a small fraction of the total notional amount of trades with a counterparty.
Current exposure (CE) is the current value of the exposure to a counterparty.
Potential future exposure (PFE) is the maximum amount of exposure expected to occur on
a future date with a high degree of statistical confidence. For example, the 95% PFE is the level of potential exposure that is exceeded with only 5% probability. The curve PFE(t),
as t varies over future dates, is the potential exposure profile, up to the final maturity of
the portfolio of trades with the counterparty. PFE(t) is usually computed through simulation
models: for each future date t, the value of the portfolio of trades with a counterparty
is simulated. A high percentile of the distribution of exposures is selected to represent the
PFE(t). The peak of PFE(t) over the life of the portfolio is referred to as maximum potential
future exposure (MPFE). PFE(t) and MPFE are often compared with credit limits in
the process of permissioning trades.
Expected exposure (EE) is the average exposure on a future date. The curve of EE(t), as t
varies over future dates, provides the expected exposure profile. The expected exposures
are computed with the same models used for PFEs. The EE(t) curve is referred to as the
‘credit-equivalent’ or ‘loan-equivalent’ exposure curve, and is used for credit pricing and
for the calculation of the economic capital of well-diversified portfolios of counterparties.
Expected positive exposure (EPE) is the average EE(t) for t in a certain interval (for example, for t during a given year).
Right-way/wrong-way exposures are exposures that are positively/negatively correlated
with the credit quality of the counterparty. Those exposures may have lower/higher expected credit losses associated with them than would be the case without correlation. A company writing put options on its own stock creates wrong-way exposures for the buyer. An oil producer selling oil in a swap creates right-way exposures for the buyer.
Credit risk mitigants are designed to reduce credit exposures. They include netting rights,
collateral agreements, and early settlement provisions.

PFE models: an overview

Over the last decade, derivatives dealers have invested large amounts of resources to build
sophisticated PFE measurement systems. Those systems comprise:

Databases (trades, agreements, legal entities, legal opinions, collateral holdings, risk limits);
Monte Carlo simulation engines;
Trade pricing calculators;
Exposure calculators; and
Reporting tools.

Simulation engine

Trade pricing

Exposure calculation

Calculating the exposure in each netting node;
Adding all netting node exposures;
Calculating the collateral posted/received for each margin node;
Adding collateral posted/received; and
Calculating the net exposure to the counterparty as (2) minus (4).

Model validation and control

Applications of exposure modeling

The most important uses of PFE models are:

Ttrade approvals against credit line limits;
Credit risk valuation; and
Economic and regulatory capital.

Market valuation of credit exposures

Risk premiums

Mean* exposure times mean* loss rate

The total market value V(t) of default risk during the t-th future time period (say, a future
calendar quarter) is computed by the following steps.

Calculate EE*(t), the risk-neutral expected exposure for period t, that is, the average of

PART III: ADVANCES IN ASSET/LIABILITY MANAGEMENT
exposures weighted by their risk-neutral probabilities, over all possible scenarios. (The
distinction between risk-neutral and actual expectations is emphasized with an asterisk.)
This is the risk-neutral expected market value that would be lost with default during that
period, with no recovery, given the effect of all applicable netting, collateral, and other
credit enhancements. This exposure measure, EE*(t), can be calculated, for example, from
derivative pricing algorithms. The risk-neutral expected exposure EE*(t) may in some
cases be significantly different than the expected exposure uncorrected for risk premiums,
and this certainly seems to be the case with U.S. Libor interest rate swaps.4

2swaps.
Calculate the risk-neutral mean default loss rate L*(t) associated with the period, which is
the product of the risk-neutral likelihood of default during the period and the risk-neutral mean fraction of exposure lost in the event of default.
3.
Obtain C(t), the price of a default-free zero-coupon bond of maturity t.
4.
Calculate V(t) = EE*(t) × L*(t) × C(t). This calculation of V(t) ignores the effect of correlation between exposure and interest rates. To correct for this, one could calculate the expected exposure EE*(t) under forward risk-neutral probabilities.5 probabilities.
Additional adjustments for correlation due to wrong-way or right-way exposure effects can sometimes be substantial. For example, a wrong-way increase in risk-neutral mean loss rates of 40 bps per 100-bp change in Libor could double the credit-risk adjustment on an interest rate swap (see Duffie and Huang, 1996). The total market value of the credit risk is V(1) + V(2) +…+ V(T), where T is the final time period of exposure to that counterparty.

General Monte Carlo approach

The algorithm is described in simple illustrative terms, and not in a complete and computationally
efficient manner, as follows.

1. Initiate a new, independently simulated scenario.
2. Simulate, for this scenario, date by date, the net exposure of Counterparty A to default by
Counterparty B. At each date, this gives the market value that would be lost if B were to
default at that date, with no recovery, with all applicable netting agreements in force, and
net of all collateral. The enforceability of netting and the valuation of collateral can also

MEASURING AND MARKING COUNTERPARTY RISK be simulated if uncertain.

3. Simulate, date by date, whether or not B defaults at that date, and whether A defaults at
that date.
4. If, at a given date, Counterparty B defaults and Counterparty A has not already defaulted,
then simulate the fraction of the net exposure, as obtained in Step 2, that is lost. This determines
the losses to A in this scenario.
5. Simulate the path of short-term interest rates.
6. Discount to present market value, using the compounded short-term interest rates for this
scenario, the losses to Counterparty A.
7. Return to Step 1, unless a sufficiently large number of scenarios have been run to obtain
the approximate effect of the law of large numbers.
8. Average the results of Step 6, over all independently generated scenarios. This average is
the estimate of the market value of default losses to Counterparty A due to default by
Counterparty B.
The net total market value of the default risk to Counterparty A is V(B)–V(A), the market
value of default losses to Counterparty A that are due to default by Counterparty B, as above,
net of the market value V(A) of the losses to Counterparty B due to default by Counterparty

A. This difference V(B)–V(A) can be positive or negative.
Example

PART III: ADVANCES IN ASSET/LIABILITY MANAGEMENT

General remarks on credit adjustments

For example, consider an interest rate swap between an outside customer Z, and one of
two possible dealers, Gilt, rated AAA, and Silver, rated BBB. Suppose that Z, rated AA,

MEASURING AND MARKING COUNTERPARTY RISK

Conclusion

It seems crucial that regulators appreciate this transformation. In particular, the framework
used to assess counterparty risk should evolve pari passu with the possibilities of risk
management.

The process of transformation of the static, buy-and-hold perception of counterparty risk
into dynamic hedging programs is irreversible.

PART III: ADVANCES IN ASSET/LIABILITY MANAGEMENT

Bibliography

Canabarro, E., E. Picoult, and T. Wilde (2003), ‘Analysing counterparty risk’, Risk Magazine,
Vol. 16, No. 19, pp. 117–122 (September).

Das, S., and R. Sundaram (1999), ‘Of Smiles and Smirks, A Term Structure Perspective’,
Journal of Financial and Quantitative Analysis, Vol. 34, pp. 211–239.

Duffie, D. (1999), ‘Credit swap valuation’, Financial Analysts Journal, January–February,
1999, pp. 73–87.

Duffie, D., and M. Huang (1996), ‘Swap rates and credit quality’, Journal of Finance, Vol.
51, pp. 921–949.

Duffie, D., and K. Singleton (2003), Credit Risk, Princeton, Princeton University Press.

Hull, J. (2000), Options, Futures, and Other Derivative Securities, 4th edition, Englewood
Cliffs, NJ, Prentice-Hall.

Kealhofer, S. (2003), ‘Quantifying credit risk I: Default prediction’, Financial Analysts
Journal, January–February, pp. 30–44.

1
See published surveys on ISDA’s website, www.isda.org.

References

Eduardo Canabarro; Head of Credit Quantitative Risk Modeling, Goldman Sachs
Darrell Duffie; Professor, Stanford University Graduate School of Business
[[credit_risk:Asset/Liability Management of Financial Insitutions|Asset/Liability Management of Financial Insitutions]]

Measuring and marking counterparty risk

Alan — Fri, 20 Mar 2009 09:48:49 GMT

Revision 5 posted to Credit Risk by Alan on 20/03/2009 09:48:49

Measuring and marking counterparty risk

Introduction

Counterparty exposures

Definitions

•

Counterparty exposure is the larger of zero and the market value of the portfolio of derivative positions with a counterparty that would be lost if the counterparty were to default and there were zero recovery. Counterparty exposures created by OTC derivatives are usually only a small fraction of the total notional amount of trades with a counterparty.
•
Current exposure (CE) is the current value of the exposure to a counterparty.
•
Potential future exposure (PFE) is the maximum amount of exposure expected to occur on
a future date with a high degree of statistical confidence. For example, the 95% PFE is the

MEASURING AND MARKING COUNTERPARTY RISK level of potential exposure that is exceeded with only 5% probability. The curve PFE(t),
as t varies over future dates, is the potential exposure profile, up to the final maturity of
the portfolio of trades with the counterparty. PFE(t) is usually computed through simulation
models: for each future date t, the value of the portfolio of trades with a counterparty
is simulated. A high percentile of the distribution of exposures is selected to represent the
PFE(t). The peak of PFE(t) over the life of the portfolio is referred to as maximum potential
future exposure (MPFE). PFE(t) and MPFE are often compared with credit limits in
the process of permissioning trades.

•
Expected exposure (EE) is the average exposure on a future date. The curve of EE(t), as t
varies over future dates, provides the expected exposure profile. The expected exposures
are computed with the same models used for PFEs. The EE(t) curve is referred to as the
‘credit-equivalent’ or ‘loan-equivalent’ exposure curve, and is used for credit pricing and
for the calculation of the economic capital of well-diversified portfolios of counterparties.
•
Expected positive exposure (EPE) is the average EE(t) for t in a certain interval (for example, for t during a given year).
•
Right-way/wrong-way exposures are exposures that are positively/negatively correlated
with the credit quality of the counterparty. Those exposures may have lower/higher expected credit losses associated with them than would be the case without correlation. A company writing put options on its own stock creates wrong-way exposures for the buyer. An oil producer selling oil in a swap creates right-way exposures for the buyer.
•
Credit risk mitigants are designed to reduce credit exposures. They include netting rights,
collateral agreements, and early settlement provisions.

Exhibit 9.1

Example of one path of counterparty ’s exposures

Time (years)
012345

Trade 001 –0.9 –1.4 0.5 0.1 –0.8 0.5
Trade 002 –0.4 –0.1 0.1 –1.4 –2.7 –3.2
Trade 003 1.1 2.0 1.7 1.2 1.4 0.8
Trade 004 –0.4 1.6 1.4 1.9 3.5 2.7
Trade 005 0.6 1.8 1.1 1.3 1.5 1.4

Exposure (US$)

Without netting 1.7 5.4 4.7 4.4 6.4 5.4

With netting 0.0 3.9 4.7 3.1 2.8 2.2

Source: Authors’ own.

PART III: ADVANCES IN ASSET/LIABILITY MANAGEMENT

having a mark to market value in favor of the bank of 80, then the exposure of the bank to the
counterparty, with netting, is 30.

Exhibit 9.1 shows an example of the time paths of the values of five trades as well as the
future exposures to the counterparty, with and without netting. Collateral agreements require counterparties to periodically mark to market their positions and to provide collateral (that is, to transfer the ownership of assets) to each other as exposures exceed pre-established thresholds. Usually the threshold schedule is a function of the credit ratings of the counterparties. Counterparties with high/low credit ratings have to post collateral if amounts due exceed high/low thresholds. Collateral agreements do not eliminate all counterparty risks: exposures may exist below the thresholds; market movements can increase the exposure between the time of the last collateral exchange and the time when default is determined and the trades are closed out; the collateral received/posted depreciates/
appreciates depreciates/appreciates in value during the close-out period.

PFE models: an overview

Over the last decade, derivatives dealers have invested large amounts of resources to build
sophisticated PFE measurement systems. Those systems comprise:

• databases

Databases (trades, agreements, legal entities, legal opinions, collateral holdings, risk limits);
•
Monte Carlo simulation engines;
• trade
Trade pricing calculators;
• exposure
Exposure calculators; and
• reporting
Reporting tools.

Simulation engine

MEASURING AND MARKING COUNTERPARTY RISK usually modeled as lognormal diffusions. This practice is in contrast with the modeling of
emerging market foreign exchange rates, where significant jumps can occur. Jump-diffusion
processes are generally employed to characterize the movements of the prices of emerging
market or pegged currencies. The stochastic processes followed by the emerging market currencies may not be Markovian: the past history of the exchange rates affects the likelihood
of a large devaluation. For example, if a currency has not been devalued for a long period of
time, then it may be more likely to be devalued in the near future. Immediately after a devaluation, the likelihood of another would be reduced. The shorter the time horizons over which PFEs are computed, the larger is the importance of modeling jumps, where required (see Das
and Sundaram, 1999). For longer horizons, the impact of jumps tends to dissipate and the
process cannot be easily distinguished from diffusion. Thus, the modeler must consider the
horizon at which the PFEs are computed. Although commodity and equity prices are usually
modeled as lognormal diffusions, it may be necessary to model jumps for some less liquid
commodities and equities.

PART III: ADVANCES IN ASSET/LIABILITY MANAGEMENT

Trade pricing

Exposure calculation

1. calculating

Calculating the exposure in each netting node;
2. adding
Adding all netting node exposures;
3. calculating
Calculating the collateral posted/received for each margin node;
4. adding
Adding collateral posted/received; and
5. calculating
Calculating the net exposure to the counterparty as (2) minus (4).

MEASURING AND MARKING COUNTERPARTY RISK and the final closing out of trades. A typical, conservative, close-out period is two weeks.

Model validation and control

Applications of exposure modeling

The most important uses of PFE models are:

• trade

Ttrade approvals against credit line limits;
• credit
Credit risk valuation; and
• economic
Economic and regulatory capital.

PART III: ADVANCES IN ASSET/LIABILITY MANAGEMENT

Market valuation of credit exposures

In practice, it is typical to view the credit adjustment on the portfolio of positions with a
given counterparty as an adjustment to the mid-market valuation of that portfolio. For example,
consider an off-market yen–U.S. dollar currency swap between A, the yen receiver, and B. Suppose the mid-market valuation of the swap to the yen receiver is 100. Suppose this
mid-market valuation already includes an effective market value of two for default risk to the
hypothetical yen receiver, net of the market value of the default risk to the hypothetical yen
payer. Suppose the actual swap between A and B has a net market value of default risk to A
of five, because the yen payer happens to be of lower than mid-market quality. Then the credit-
risk adjustment is a downward adjustment of three, leaving a fair market value to A of 97.
In many cases, however, the default risk portion of the mid-market valuation is small and
ignored, causing the credit adjustment to mid-market valuation to coincide with the total measured market value of the credit risk of the OTC position. Mid-market valuations of at-market interest rate swaps, for example, are based on hypothetical counterparties of equal and high (say, AA) quality, so the effects of default risk are essentially offsetting. They need not be precisely offsetting, as the fixed-rate payer has slightly different expected exposures than the floating-rate payer. For example, in an upward-sloping yield curve environment, we expect the exposure to the floating-rate receiver to grow over time, as the floating rate is expected to grow, in a risk-neutral sense. Even so, on a plain-vanilla U.S. dollar interest rate swap between AA counterparties, the net market value of counter-
party counter-party default risk associated with mid-market valuations is often indeed negligible. This may not be the case for other OTC positions, especially those with large expected exposures to only one of the two counterparties, such as long-dated options and off-market swaps.

Risk premiums

MEASURING AND MARKING COUNTERPARTY RISK lost. The actual default probability might be estimated, for example, by the Moody’s-KMV
EDF measure (see Kealhofer, 2003). The mean loss rate is therefore 15%, the product of the
loss probability with the fraction lost given default. We will ignore the time value of money
for this example, taking interest rates to be zero. Given the mean loss rate of 15%, the expected
payoff of the bond is 85,000. Investors, however, would typically pay less than 85,000 for
this defaultable bond. In order to give an investor an incentive to buy this risky bond rather
than a default-free bond with a payoff of 85,000, the market price of the defaultable bond
must normally be something less than its expected payoff. For example, the defaultable bond
may have a market price of 80,000. This means that, for pricing and trading purposes, bond
investors may act as though they are neutral to risk, but assign an artificially high mean loss
rate of 20%. In this sense, 20% is called the ‘risk-neutral mean loss rate’. The risk-neutral
mean loss rate is a key input to bond pricing and other credit risk pricing applications.

Mean* exposure times mean* loss rate

The total market value V(t) of default risk during the t-th future time period (say, a future
calendar quarter) is computed by the following steps.

1. Calculate EE*(t), the risk-neutral expected exposure for period t, that is, the average of

PART III: ADVANCES IN ASSET/LIABILITY MANAGEMENT

exposures weighted by their risk-neutral probabilities, over all possible scenarios. (The
distinction between risk-neutral and actual expectations is emphasized with an asterisk.)
This is the risk-neutral expected market value that would be lost with default during that
period, with no recovery, given the effect of all applicable netting, collateral, and other
credit enhancements. This exposure measure, EE*(t), can be calculated, for example, from
derivative pricing algorithms. The risk-neutral expected exposure EE*(t) may in some
cases be significantly different than the expected exposure uncorrected for risk premiums,
and this certainly seems to be the case with U.S. Libor interest rate swaps.4

2. Calculate the risk-neutral mean default loss rate L*(t) associated with the period, which is
the product of the risk-neutral likelihood of default during the period and the risk-neutral
mean fraction of exposure lost in the event of default.
3. Obtain C(t), the price of a default-free zero-coupon bond of maturity t.
4. Calculate V(t) = EE*(t) × L*(t) × C(t).
This calculation of V(t) ignores the effect of correlation between exposure and interest
rates. To correct for this, one could calculate the expected exposure EE*(t) under forward
risk-neutral probabilities.5 Additional adjustments for correlation due to wrong-way or
right-way exposure effects can sometimes be substantial. For example, a wrong-way
increase in risk-neutral mean loss rates of 40 bps per 100-bp change in Libor could double
the credit-risk adjustment on an interest rate swap (see Duffie and Huang, 1996). The total
market value of the credit risk is V(1) + V(2) +…+ V(T), where T is the final time period
of exposure to that counterparty.

General Monte Carlo approach

The algorithm is described in simple illustrative terms, and not in a complete and computationally
efficient manner, as follows.

be simulated if uncertain.

A. This difference V(B)–V(A) can be positive or negative.
Example

PART III: ADVANCES IN ASSET/LIABILITY MANAGEMENT

General remarks on credit adjustments

For example, consider an interest rate swap between an outside customer Z, and one of
two possible dealers, Gilt, rated AAA, and Silver, rated BBB. Suppose that Z, rated AA,

MEASURING AND MARKING COUNTERPARTY RISK

Conclusion

The traditional potential-exposure framework discussed in the first part of this chapter
takes a static buy-and-hold view of counterparty risks, without incorporating the possibility of
dynamic hedging of liquid credit risks. As the liquidity and completeness of the credit derivatives
market continues to grow, more and more counterparty risks will become hedgeable.
Static potential exposure measures will be superseded by Value-at-Risk (VaR) and stress limits
similar to those currently used for other liquid market risks (such as those inherent in interest
rates and currencies). Some firms have adopted internal credit risk hedging via desks whose
purpose is to provide credit protection, at a transfer price, to other desks within the firm and
then to choose how much of the firm’s net exposure to each counterparty is to be traded to outside
counterparties. More decentralized firms have desk-by-desk hedging of credit risks.

It seems crucial that regulators appreciate this transformation. In particular, the framework
used to assess counterparty risk should evolve pari passu with the possibilities of risk
management.

The process of transformation of the static, buy-and-hold perception of counterparty risk
into dynamic hedging programs is irreversible.

PART III: ADVANCES IN ASSET/LIABILITY MANAGEMENT

Bibliography

Canabarro, E., E. Picoult, and T. Wilde (2003), ‘Analysing counterparty risk’, Risk Magazine,
Vol. 16, No. 19, pp. 117–122 (September).

Das, S., and R. Sundaram (1999), ‘Of Smiles and Smirks, A Term Structure Perspective’,
Journal of Financial and Quantitative Analysis, Vol. 34, pp. 211–239.

Duffie, D. (1999), ‘Credit swap valuation’, Financial Analysts Journal, January–February,
1999, pp. 73–87.

Duffie, D., and M. Huang (1996), ‘Swap rates and credit quality’, Journal of Finance, Vol.
51, pp. 921–949.

Duffie, D., and K. Singleton (2003), Credit Risk, Princeton, Princeton University Press.

Hull, J. (2000), Options, Futures, and Other Derivative Securities, 4th edition, Englewood
Cliffs, NJ, Prentice-Hall.

Kealhofer, S. (2003), ‘Quantifying credit risk I: Default prediction’, Financial Analysts
Journal, January–February, pp. 30–44.

1
See published surveys on ISDA’s website, www.isda.org.

References

Eduardo Canabarro; Head of Credit Quantitative Risk Modeling, Goldman Sachs
Darrell Duffie; Professor, Stanford University Graduate School of Business
[[credit_risk:Asset/Liability Management of Financial Insitutions|Asset/Liability Management of Financial Insitutions]]

Measuring and marking counterparty risk

Alan — Fri, 20 Mar 2009 09:19:55 GMT

Revision 4 posted to Credit Risk by Alan on 20/03/2009 09:19:55

Measuring and marking counterparty risk

Introduction

The volume of outstanding OTC derivatives has grown exponentially over the past 15 years.
Market surveys conducted by the International Swaps and Derivatives Association (ISDA)
show notional amounts of outstanding interest rate and currency swaps reaching US$866 billion
in 1987, US$17.7 trillion in 1995, and US$99.8 trillion in 2002; an astonishing compounded
growth rate of 37.2% per year.1 Derivatives have expanded the opportunities to
transfer risks, allowing for substantially improved risk sharing. They have also created connections
among markets and market participants that are only just starting to be understood.

Counterparty exposures

Definitions

•
Counterparty exposure is the larger of zero and the market value of the portfolio of derivative
positions with a counterparty that would be lost if the counterparty were to default
and there were zero recovery. Counterparty exposures created by OTC derivatives are usually
only a small fraction of the total notional amount of trades with a counterparty.
•
Current exposure (CE) is the current value of the exposure to a counterparty.
•
Potential future exposure (PFE) is the maximum amount of exposure expected to occur on
a future date with a high degree of statistical confidence. For example, the 95% PFE is the

MEASURING AND MARKING COUNTERPARTY RISK

level of potential exposure that is exceeded with only 5% probability. The curve PFE(t),
as t varies over future dates, is the potential exposure profile, up to the final maturity of
the portfolio of trades with the counterparty. PFE(t) is usually computed through simulation
models: for each future date t, the value of the portfolio of trades with a counterparty
is simulated. A high percentile of the distribution of exposures is selected to represent the
PFE(t). The peak of PFE(t) over the life of the portfolio is referred to as maximum potential
future exposure (MPFE). PFE(t) and MPFE are often compared with credit limits in
the process of permissioning trades.

•
Expected exposure (EE) is the average exposure on a future date. The curve of EE(t), as t
varies over future dates, provides the expected exposure profile. The expected exposures
are computed with the same models used for PFEs. The EE(t) curve is referred to as the
‘credit-equivalent’ or ‘loan-equivalent’ exposure curve, and is used for credit pricing and
for the calculation of the economic capital of well-diversified portfolios of counterparties.
•
Expected positive exposure (EPE) is the average EE(t) for t in a certain interval (for example,
for t during a given year).
•
Right-way/wrong-way exposures are exposures that are positively/negatively correlated
with the credit quality of the counterparty. Those exposures may have lower/higher expected
credit losses associated with them than would be the case without correlation. A company
writing put options on its own stock creates wrong-way exposures for the buyer. An
oil producer selling oil in a swap creates right-way exposures for the buyer.
•
Credit risk mitigants are designed to reduce credit exposures. They include netting rights,
collateral agreements, and early settlement provisions.
Examining these credit risk mitigants in more detail, legally enforceable netting agreements
allow trades to be offset when determining the net payable amount upon the default of the
counterparty. Without netting, the position of the non-defaulting party would be a loss of the
full value of the out-of-the-money trades against a claim on the total value of the in-themoney
trades. With netting, positives and negatives are added first to determine the net payment
due. For example, if a counterparty holds a currency option written by its bank with a
market value of 50, while the bank has an interest rate swap with the same counterparty

Exhibit 9.1

Example of one path of counterparty’s exposures

Time (years)
012345

Trade 001 –0.9 –1.4 0.5 0.1 –0.8 0.5
Trade 002 –0.4 –0.1 0.1 –1.4 –2.7 –3.2
Trade 003 1.1 2.0 1.7 1.2 1.4 0.8
Trade 004 –0.4 1.6 1.4 1.9 3.5 2.7
Trade 005 0.6 1.8 1.1 1.3 1.5 1.4

Exposure (US$)

Without netting 1.7 5.4 4.7 4.4 6.4 5.4

With netting 0.0 3.9 4.7 3.1 2.8 2.2

Source: Authors’ own.

PART III: ADVANCES IN ASSET/LIABILITY MANAGEMENT

having a mark to market value in favor of the bank of 80, then the exposure of the bank to the
counterparty, with netting, is 30.

Exhibit 9.1 shows an example of the time paths of the values of five trades as well as the
future exposures to the counterparty, with and without netting.

Collateral agreements require counterparties to periodically mark to market their positions
and to provide collateral (that is, to transfer the ownership of assets) to each other as
exposures exceed pre-established thresholds. Usually the threshold schedule is a function of
the credit ratings of the counterparties. Counterparties with high/low credit ratings have to
post collateral if amounts due exceed high/low thresholds. Collateral agreements do not eliminate
all counterparty risks: exposures may exist below the thresholds; market movements can
increase the exposure between the time of the last collateral exchange and the time when
default is determined and the trades are closed out; the collateral received/posted depreciates/
appreciates in value during the close-out period.

PFE models: an overview

Over the last decade, derivatives dealers have invested large amounts of resources to build
sophisticated PFE measurement systems. Those systems comprise:

• databases (trades, agreements, legal entities, legal opinions, collateral holdings, risk limits);
• Monte Carlo simulation engines;
• trade pricing calculators;
• exposure calculators; and
• reporting tools.
The estimation of PFEs requires sophisticated models to simulate exposures in market scenarios
on various future dates. The specification of the PFE model and its ongoing validation
are of paramount importance. In the following subsections alternative model specifications
are discussed, and certain choices and trade-offs are highlighted.

Simulation engine

MEASURING AND MARKING COUNTERPARTY RISK

usually modeled as lognormal diffusions. This practice is in contrast with the modeling of
emerging market foreign exchange rates, where significant jumps can occur. Jump-diffusion
processes are generally employed to characterize the movements of the prices of emerging
market or pegged currencies. The stochastic processes followed by the emerging market currencies
may not be Markovian: the past history of the exchange rates affects the likelihood
of a large devaluation. For example, if a currency has not been devalued for a long period of
time, then it may be more likely to be devalued in the near future. Immediately after a devaluation,
the likelihood of another would be reduced. The shorter the time horizons over which
PFEs are computed, the larger is the importance of modeling jumps, where required (see Das
and Sundaram, 1999). For longer horizons, the impact of jumps tends to dissipate and the
process cannot be easily distinguished from diffusion. Thus, the modeler must consider the
horizon at which the PFEs are computed. Although commodity and equity prices are usually
modeled as lognormal diffusions, it may be necessary to model jumps for some less liquid
commodities and equities.

PART III: ADVANCES IN ASSET/LIABILITY MANAGEMENT

Trade pricing

Once a future market scenario is generated, in order to calculate the exposure in that scenario,
all trades with the counterparty must be priced. That task consumes large computational
resources. Imagine a swap dealer’s book with 100,000 positions, with average maturity of
seven years, and 2,000 market scenarios generated every three months. One would need to perform
5.6 billion pricings. At, for example, 100 microseconds per pricing, this would correspond
to 156 hours of CPU time. Clearly, a good amount of financial and software engineering
is required. In the early history of risk measurement, some large dealers retained super-computers
for the computation of the credit exposures generated by their portfolios of OTC derivatives.
Others developed heavily engineered algorithms to economize on the computation time
(incorporating price grids, sophisticated interpolation schemes in both time and space dimensions,
and so on). More recently, distributed/parallel processing has been employed.
Unnecessary pricing complexity should be avoided: one should avoid refining within the margin
of error. This is particularly important for long-dated exposures: the volatilities, correlations
and probabilistic assumptions used in constructing the long-dated scenarios are
themselves surrounded by considerable uncertainty. Constructing highly accurate (and computationally
intensive) pricing calculators often qualifies as refining within the margin of error.

Exposure calculation

1. calculating the exposure in each netting node;
2. adding all netting node exposures;
3. calculating the collateral posted/received for each margin node;
4. adding collateral posted/received; and
5. calculating the net exposure to the counterparty as (2) minus (4).
The calculation method above, (1)–(5), implies that a counterparty with one netting node, one
coincident margin node, and a zero collateral threshold would generate zero exposure.
Sophisticated PFE models recognize that collateral does not change hands continuously and
instantaneously. These models allow for a period of time between an event causing default

MEASURING AND MARKING COUNTERPARTY RISK

and the final closing out of trades. A typical, conservative, close-out period is two weeks.

Model validation and control

Applications of exposure modeling

The most important uses of PFE models are:

• trade approvals against credit line limits;
• credit risk valuation; and
• economic and regulatory capital.
Credit officers set limits on PFE profiles. The limits tend to be wider for short terms and
tighter for long terms. In the process of permissioning new trades, the PFE profile to a counterparty
is re-computed including the new trades. The PFE profile is then compared with the
limit schedule. PFE models also generate the inputs for credit risk valuation. When exposures
are uncorrelated with the credit quality of the counterparty, the unconditional expected exposure
profile is used for valuation.

PART III: ADVANCES IN ASSET/LIABILITY MANAGEMENT

Market valuation of credit exposures

B. Suppose the mid-market valuation of the swap to the yen receiver is 100. Suppose this
mid-market valuation already includes an effective market value of two for default risk to the
hypothetical yen receiver, net of the market value of the default risk to the hypothetical yen
payer. Suppose the actual swap between A and B has a net market value of default risk to A
of five, because the yen payer happens to be of lower than mid-market quality. Then the credit-
risk adjustment is a downward adjustment of three, leaving a fair market value to A of 97.
In many cases, however, the default risk portion of the mid-market valuation is small and
ignored, causing the credit adjustment to mid-market valuation to coincide with the total measured
market value of the credit risk of the OTC position.
Mid-market valuations of at-market interest rate swaps, for example, are based on hypothetical
counterparties of equal and high (say, AA) quality, so the effects of default risk are
essentially offsetting. They need not be precisely offsetting, as the fixed-rate payer has slightly
different expected exposures than the floating-rate payer. For example, in an upward-sloping
yield curve environment, we expect the exposure to the floating-rate receiver to grow over
time, as the floating rate is expected to grow, in a risk-neutral sense. Even so, on a plain-vanilla
U.S. dollar interest rate swap between AA counterparties, the net market value of counter-
party default risk associated with mid-market valuations is often indeed negligible. This may
not be the case for other OTC positions, especially those with large expected exposures to
only one of the two counterparties, such as long-dated options and off-market swaps.

Risk premiums

MEASURING AND MARKING COUNTERPARTY RISK

lost. The actual default probability might be estimated, for example, by the Moody’s-KMV
EDF measure (see Kealhofer, 2003). The mean loss rate is therefore 15%, the product of the
loss probability with the fraction lost given default. We will ignore the time value of money
for this example, taking interest rates to be zero. Given the mean loss rate of 15%, the expected
payoff of the bond is 85,000. Investors, however, would typically pay less than 85,000 for
this defaultable bond. In order to give an investor an incentive to buy this risky bond rather
than a default-free bond with a payoff of 85,000, the market price of the defaultable bond
must normally be something less than its expected payoff. For example, the defaultable bond
may have a market price of 80,000. This means that, for pricing and trading purposes, bond
investors may act as though they are neutral to risk, but assign an artificially high mean loss
rate of 20%. In this sense, 20% is called the ‘risk-neutral mean loss rate’. The risk-neutral
mean loss rate is a key input to bond pricing and other credit risk pricing applications.

Mean* exposure times mean* loss rate

The total market value V(t) of default risk during the t-th future time period (say, a future
calendar quarter) is computed by the following steps.

1. Calculate EE*(t), the risk-neutral expected exposure for period t, that is, the average of

PART III: ADVANCES IN ASSET/LIABILITY MANAGEMENT

General Monte Carlo approach

The algorithm is described in simple illustrative terms, and not in a complete and computationally
efficient manner, as follows.

be simulated if uncertain.

A. This difference V(B)–V(A) can be positive or negative.
Example

PART III: ADVANCES IN ASSET/LIABILITY MANAGEMENT

General remarks on credit adjustments

For example, consider an interest rate swap between an outside customer Z, and one of
two possible dealers, Gilt, rated AAA, and Silver, rated BBB. Suppose that Z, rated AA,

MEASURING AND MARKING COUNTERPARTY RISK

Conclusion

The traditional potential-exposure framework discussed in the first part of this chapter
takes a static buy-and-hold view of counterparty risks, without incorporating the possibility of
dynamic hedging of liquid credit risks. As the liquidity and completeness of the credit derivatives
market continues to grow, more and more counterparty risks will become hedgeable.
Static potential exposure measures will be superseded by Value-at-Risk (VaR) and stress limits
similar to those currently used for other liquid market risks (such as those inherent in interest
rates and currencies). Some firms have adopted internal credit risk hedging via desks whose
purpose is to provide credit protection, at a transfer price, to other desks within the firm and
then to choose how much of the firm’s net exposure to each counterparty is to be traded to outside
counterparties. More decentralized firms have desk-by-desk hedging of credit risks.

It seems crucial that regulators appreciate this transformation. In particular, the framework
used to assess counterparty risk should evolve pari passu with the possibilities of risk
management.

The process of transformation of the static, buy-and-hold perception of counterparty risk
into dynamic hedging programs is irreversible.

PART III: ADVANCES IN ASSET/LIABILITY MANAGEMENT

Bibliography

Canabarro, E., E. Picoult, and T. Wilde (2003), ‘Analysing counterparty risk’, Risk Magazine,
Vol. 16, No. 19, pp. 117–122 (September).

Das, S., and R. Sundaram (1999), ‘Of Smiles and Smirks, A Term Structure Perspective’,
Journal of Financial and Quantitative Analysis, Vol. 34, pp. 211–239.

Duffie, D. (1999), ‘Credit swap valuation’, Financial Analysts Journal, January–February,
1999, pp. 73–87.

Duffie, D., and M. Huang (1996), ‘Swap rates and credit quality’, Journal of Finance, Vol.
51, pp. 921–949.

Duffie, D., and K. Singleton (2003), Credit Risk, Princeton, Princeton University Press.

Hull, J. (2000), Options, Futures, and Other Derivative Securities, 4th edition, Englewood
Cliffs, NJ, Prentice-Hall.

Kealhofer, S. (2003), ‘Quantifying credit risk I: Default prediction’, Financial Analysts
Journal, January–February, pp. 30–44.

1
See published surveys on ISDA’s website, www.isda.org.

References

Eduardo Canabarro; Head of Credit Quantitative Risk Modeling, Goldman Sachs
Darrell Duffie; Professor, Stanford University Graduate School of Business
Asset/Liability
[[credit_risk:Asset/Liability Management of Financial InsitutionsInsitutions|Asset/Liability Management of Financial Insitutions]]

Measuring and marking counterparty risk

Alan — Fri, 20 Mar 2009 09:15:25 GMT

Revision 3 posted to Credit Risk by Alan on 20/03/2009 09:15:25

Measuring and marking counterparty risk

Eduardo Canabarro

Head of Credit Quantitative Risk Modeling, Goldman Sachs

Darrell Duffie

Professor, Stanford University Graduate School of Business

Introduction

The volume of outstanding OTC derivatives has grown exponentially over the past 15 years.
Market surveys conducted by the International Swaps and Derivatives Association (ISDA)
show notional amounts of outstanding interest rate and currency swaps reaching US$866 billion
in 1987, US$17.7 trillion in 1995, and US$99.8 trillion in 2002; an astonishing compounded
growth rate of 37.2% per year.1 Derivatives have expanded the opportunities to
transfer risks, allowing for substantially improved risk sharing. They have also created connections
among markets and market participants that are only just starting to be understood.

Counterparty exposures

Definitions

Exhibit 9.1

Example of one path of counterparty’s exposures

Time (years)
012345

Trade 001 –0.9 –1.4 0.5 0.1 –0.8 0.5
Trade 002 –0.4 –0.1 0.1 –1.4 –2.7 –3.2
Trade 003 1.1 2.0 1.7 1.2 1.4 0.8
Trade 004 –0.4 1.6 1.4 1.9 3.5 2.7
Trade 005 0.6 1.8 1.1 1.3 1.5 1.4

Exposure (US$)

Without netting 1.7 5.4 4.7 4.4 6.4 5.4

With netting 0.0 3.9 4.7 3.1 2.8 2.2

Source: Authors’ own.

PART III: ADVANCES IN ASSET/LIABILITY MANAGEMENT

having a mark to market value in favor of the bank of 80, then the exposure of the bank to the
counterparty, with netting, is 30.

Exhibit 9.1 shows an example of the time paths of the values of five trades as well as the
future exposures to the counterparty, with and without netting.

PFE models: an overview

Over the last decade, derivatives dealers have invested large amounts of resources to build
sophisticated PFE measurement systems. Those systems comprise:

Simulation engine

MEASURING AND MARKING COUNTERPARTY RISK

PART III: ADVANCES IN ASSET/LIABILITY MANAGEMENT

Trade pricing

Once a future market scenario is generated, in order to calculate the exposure in that scenario,
all trades with the counterparty must be priced. That task consumes large computational
resources. Imagine a swap dealer’s book with 100,000 positions, with average maturity of
seven years, and 2,000 market scenarios generated every three months. One would need to perform
5.6 billion pricings. At, for example, 100 microseconds per pricing, this would correspond
to 156 hours of CPU time. Clearly, a good amount of financial and software engineering
is required. In the early history of risk measurement, some large dealers retained super-computers
for the computation of the credit exposures generated by their portfolios of OTC derivatives.
Others developed heavily engineered algorithms to economize on the computation time
(incorporating price grids, sophisticated interpolation schemes in both time and space dimensions,
and so on). More recently, distributed/parallel processing has been employed.
Unnecessary pricing complexity should be avoided: one should avoid refining within the margin
of error. This is particularly important for long-dated exposures: the volatilities, correlations
and probabilistic assumptions used in constructing the long-dated scenarios are
themselves surrounded by considerable uncertainty. Constructing highly accurate (and computationally
intensive) pricing calculators often qualifies as refining within the margin of error.

Exposure calculation

MEASURING AND MARKING COUNTERPARTY RISK

and the final closing out of trades. A typical, conservative, close-out period is two weeks.

Model validation and control

Applications of exposure modeling

The most important uses of PFE models are:

PART III: ADVANCES IN ASSET/LIABILITY MANAGEMENT

Market valuation of credit exposures

Risk premiums

MEASURING AND MARKING COUNTERPARTY RISK

Mean* exposure times mean* loss rate

The total market value V(t) of default risk during the t-th future time period (say, a future
calendar quarter) is computed by the following steps.

1. Calculate EE*(t), the risk-neutral expected exposure for period t, that is, the average of

PART III: ADVANCES IN ASSET/LIABILITY MANAGEMENT

General Monte Carlo approach

The algorithm is described in simple illustrative terms, and not in a complete and computationally
efficient manner, as follows.

be simulated if uncertain.

A. This difference V(B)–V(A) can be positive or negative.
Example

PART III: ADVANCES IN ASSET/LIABILITY MANAGEMENT

General remarks on credit adjustments

For example, consider an interest rate swap between an outside customer Z, and one of
two possible dealers, Gilt, rated AAA, and Silver, rated BBB. Suppose that Z, rated AA,

MEASURING AND MARKING COUNTERPARTY RISK

Conclusion

The traditional potential-exposure framework discussed in the first part of this chapter
takes a static buy-and-hold view of counterparty risks, without incorporating the possibility of
dynamic hedging of liquid credit risks. As the liquidity and completeness of the credit derivatives
market continues to grow, more and more counterparty risks will become hedgeable.
Static potential exposure measures will be superseded by Value-at-Risk (VaR) and stress limits
similar to those currently used for other liquid market risks (such as those inherent in interest
rates and currencies). Some firms have adopted internal credit risk hedging via desks whose
purpose is to provide credit protection, at a transfer price, to other desks within the firm and
then to choose how much of the firm’s net exposure to each counterparty is to be traded to outside
counterparties. More decentralized firms have desk-by-desk hedging of credit risks.

It seems crucial that regulators appreciate this transformation. In particular, the framework
used to assess counterparty risk should evolve pari passu with the possibilities of risk
management.

The process of transformation of the static, buy-and-hold perception of counterparty risk
into dynamic hedging programs is irreversible.

PART III: ADVANCES IN ASSET/LIABILITY MANAGEMENT

Bibliography

Canabarro, E., E. Picoult, and T. Wilde (2003), ‘Analysing counterparty risk’, Risk Magazine,
Vol. 16, No. 19, pp. 117–122 (September).

Das, S., and R. Sundaram (1999), ‘Of Smiles and Smirks, A Term Structure Perspective’,
Journal of Financial and Quantitative Analysis, Vol. 34, pp. 211–239.

Duffie, D. (1999), ‘Credit swap valuation’, Financial Analysts Journal, January–February,
1999, pp. 73–87.

Duffie, D., and M. Huang (1996), ‘Swap rates and credit quality’, Journal of Finance, Vol.
51, pp. 921–949.

Duffie, D., and K. Singleton (2003), Credit Risk, Princeton, Princeton University Press.

Hull, J. (2000), Options, Futures, and Other Derivative Securities, 4th edition, Englewood
Cliffs, NJ, Prentice-Hall.

Kealhofer, S. (2003), ‘Quantifying credit risk I: Default prediction’, Financial Analysts
Journal, January–February, pp. 30–44.

1
See published surveys on ISDA’s website, www.isda.org.

References

Eduardo Canabarro; Head of Credit Quantitative Risk Modeling, Goldman Sachs
Darrell Duffie; Professor, Stanford University Graduate School of Business
Asset/Liability Management of Financial Insitutions

Measuring and marking counterparty risk

Alan — Thu, 05 Mar 2009 20:54:59 GMT

Revision 2 posted to Credit Risk by Alan on 05/03/2009 20:54:59

Measuring and marking counterparty risk

Eduardo Canabarro

Head of Credit Quantitative Risk Modeling, Goldman Sachs

Darrell Duffie

Professor, Stanford University Graduate School of Business

Introduction

The volume of outstanding OTC derivatives has grown exponentially over the past 15 years.
Market surveys conducted by the International Swaps and Derivatives Association (ISDA)
show notional amounts of outstanding interest rate and currency swaps reaching US$866 billion
in 1987, US$17.7 trillion in 1995, and US$99.8 trillion in 2002; an astonishing compounded
growth rate of 37.2% per year.1 Derivatives have expanded the opportunities to
transfer risks, allowing for substantially improved risk sharing. They have also created connections
among markets and market participants that are only just starting to be understood.

Counterparty exposures

Definitions

Exhibit 9.1

Example of one path of counterparty’s exposures

Time (years)
012345

Trade 001 –0.9 –1.4 0.5 0.1 –0.8 0.5
Trade 002 –0.4 –0.1 0.1 –1.4 –2.7 –3.2
Trade 003 1.1 2.0 1.7 1.2 1.4 0.8
Trade 004 –0.4 1.6 1.4 1.9 3.5 2.7
Trade 005 0.6 1.8 1.1 1.3 1.5 1.4

Exposure (US$)

Without netting 1.7 5.4 4.7 4.4 6.4 5.4

With netting 0.0 3.9 4.7 3.1 2.8 2.2

Source: Authors’ own.

PART III: ADVANCES IN ASSET/LIABILITY MANAGEMENT

having a mark to market value in favor of the bank of 80, then the exposure of the bank to the
counterparty, with netting, is 30.

Exhibit 9.1 shows an example of the time paths of the values of five trades as well as the
future exposures to the counterparty, with and without netting.

PFE models: an overview

Over the last decade, derivatives dealers have invested large amounts of resources to build
sophisticated PFE measurement systems. Those systems comprise:

Simulation engine

MEASURING AND MARKING COUNTERPARTY RISK

PART III: ADVANCES IN ASSET/LIABILITY MANAGEMENT

Trade pricing

Once a future market scenario is generated, in order to calculate the exposure in that scenario,
all trades with the counterparty must be priced. That task consumes large computational
resources. Imagine a swap dealer’s book with 100,000 positions, with average maturity of
seven years, and 2,000 market scenarios generated every three months. One would need to perform
5.6 billion pricings. At, for example, 100 microseconds per pricing, this would correspond
to 156 hours of CPU time. Clearly, a good amount of financial and software engineering
is required. In the early history of risk measurement, some large dealers retained super-computers
for the computation of the credit exposures generated by their portfolios of OTC derivatives.
Others developed heavily engineered algorithms to economize on the computation time
(incorporating price grids, sophisticated interpolation schemes in both time and space dimensions,
and so on). More recently, distributed/parallel processing has been employed.
Unnecessary pricing complexity should be avoided: one should avoid refining within the margin
of error. This is particularly important for long-dated exposures: the volatilities, correlations
and probabilistic assumptions used in constructing the long-dated scenarios are
themselves surrounded by considerable uncertainty. Constructing highly accurate (and computationally
intensive) pricing calculators often qualifies as refining within the margin of error.

Exposure calculation

MEASURING AND MARKING COUNTERPARTY RISK

and the final closing out of trades. A typical, conservative, close-out period is two weeks.

Model validation and control

Applications of exposure modeling

The most important uses of PFE models are:

PART III: ADVANCES IN ASSET/LIABILITY MANAGEMENT

Market valuation of credit exposures

Risk premiums

MEASURING AND MARKING COUNTERPARTY RISK

Mean* exposure times mean* loss rate

The total market value V(t) of default risk during the t-th future time period (say, a future
calendar quarter) is computed by the following steps.

1. Calculate EE*(t), the risk-neutral expected exposure for period t, that is, the average of

PART III: ADVANCES IN ASSET/LIABILITY MANAGEMENT

General Monte Carlo approach

The algorithm is described in simple illustrative terms, and not in a complete and computationally
efficient manner, as follows.

be simulated if uncertain.

A. This difference V(B)–V(A) can be positive or negative.
Example

PART III: ADVANCES IN ASSET/LIABILITY MANAGEMENT

General remarks on credit adjustments

For example, consider an interest rate swap between an outside customer Z, and one of
two possible dealers, Gilt, rated AAA, and Silver, rated BBB. Suppose that Z, rated AA,

MEASURING AND MARKING COUNTERPARTY RISK

Conclusion

The traditional potential-exposure framework discussed in the first part of this chapter
takes a static buy-and-hold view of counterparty risks, without incorporating the possibility of
dynamic hedging of liquid credit risks. As the liquidity and completeness of the credit derivatives
market continues to grow, more and more counterparty risks will become hedgeable.
Static potential exposure measures will be superseded by Value-at-Risk (VaR) and stress limits
similar to those currently used for other liquid market risks (such as those inherent in interest
rates and currencies). Some firms have adopted internal credit risk hedging via desks whose
purpose is to provide credit protection, at a transfer price, to other desks within the firm and
then to choose how much of the firm’s net exposure to each counterparty is to be traded to outside
counterparties. More decentralized firms have desk-by-desk hedging of credit risks.

It seems crucial that regulators appreciate this transformation. In particular, the framework
used to assess counterparty risk should evolve pari passu with the possibilities of risk
management.

The process of transformation of the static, buy-and-hold perception of counterparty risk
into dynamic hedging programs is irreversible.

PART III: ADVANCES IN ASSET/LIABILITY MANAGEMENT

Bibliography

Canabarro, E., E. Picoult, and T. Wilde (2003), ‘Analysing counterparty risk’, Risk Magazine,
Vol. 16, No. 19, pp. 117–122 (September).

Das, S., and R. Sundaram (1999), ‘Of Smiles and Smirks, A Term Structure Perspective’,
Journal of Financial and Quantitative Analysis, Vol. 34, pp. 211–239.

Duffie, D. (1999), ‘Credit swap valuation’, Financial Analysts Journal, January–February,
1999, pp. 73–87.

Duffie, D., and M. Huang (1996), ‘Swap rates and credit quality’, Journal of Finance, Vol.
51, pp. 921–949.

Duffie, D., and K. Singleton (2003), Credit Risk, Princeton, Princeton University Press.

Hull, J. (2000), Options, Futures, and Other Derivative Securities, 4th edition, Englewood
Cliffs, NJ, Prentice-Hall.

Kealhofer, S. (2003), ‘Quantifying credit risk I: Default prediction’, Financial Analysts
Journal, January–February, pp. 30–44.

1
See published surveys on ISDA’s website, www.isda.org.

Measuring and marking counterparty risk

Alan — Thu, 05 Mar 2009 20:54:59 GMT

Revision 1 posted to Credit Risk by Alan on 05/03/2009 20:54:59

Eduardo Canabarro

Head of Credit Quantitative Risk Modeling, Goldman Sachs

Darrell Duffie

Professor, Stanford University Graduate School of Business

Introduction

The volume of outstanding OTC derivatives has grown exponentially over the past 15 years.
Market surveys conducted by the International Swaps and Derivatives Association (ISDA)
show notional amounts of outstanding interest rate and currency swaps reaching US$866 billion
in 1987, US$17.7 trillion in 1995, and US$99.8 trillion in 2002; an astonishing compounded
growth rate of 37.2% per year.1 Derivatives have expanded the opportunities to
transfer risks, allowing for substantially improved risk sharing. They have also created connections
among markets and market participants that are only just starting to be understood.

Counterparty exposures

Definitions

Exhibit 9.1

Example of one path of counterparty’s exposures

Time (years)
012345

Trade 001 –0.9 –1.4 0.5 0.1 –0.8 0.5
Trade 002 –0.4 –0.1 0.1 –1.4 –2.7 –3.2
Trade 003 1.1 2.0 1.7 1.2 1.4 0.8
Trade 004 –0.4 1.6 1.4 1.9 3.5 2.7
Trade 005 0.6 1.8 1.1 1.3 1.5 1.4

Exposure (US$)

Without netting 1.7 5.4 4.7 4.4 6.4 5.4

With netting 0.0 3.9 4.7 3.1 2.8 2.2

Source: Authors’ own.

PART III: ADVANCES IN ASSET/LIABILITY MANAGEMENT

having a mark to market value in favor of the bank of 80, then the exposure of the bank to the
counterparty, with netting, is 30.

Exhibit 9.1 shows an example of the time paths of the values of five trades as well as the
future exposures to the counterparty, with and without netting.

PFE models: an overview

Over the last decade, derivatives dealers have invested large amounts of resources to build
sophisticated PFE measurement systems. Those systems comprise:

Simulation engine

MEASURING AND MARKING COUNTERPARTY RISK

PART III: ADVANCES IN ASSET/LIABILITY MANAGEMENT

Trade pricing

Once a future market scenario is generated, in order to calculate the exposure in that scenario,
all trades with the counterparty must be priced. That task consumes large computational
resources. Imagine a swap dealer’s book with 100,000 positions, with average maturity of
seven years, and 2,000 market scenarios generated every three months. One would need to perform
5.6 billion pricings. At, for example, 100 microseconds per pricing, this would correspond
to 156 hours of CPU time. Clearly, a good amount of financial and software engineering
is required. In the early history of risk measurement, some large dealers retained super-computers
for the computation of the credit exposures generated by their portfolios of OTC derivatives.
Others developed heavily engineered algorithms to economize on the computation time
(incorporating price grids, sophisticated interpolation schemes in both time and space dimensions,
and so on). More recently, distributed/parallel processing has been employed.
Unnecessary pricing complexity should be avoided: one should avoid refining within the margin
of error. This is particularly important for long-dated exposures: the volatilities, correlations
and probabilistic assumptions used in constructing the long-dated scenarios are
themselves surrounded by considerable uncertainty. Constructing highly accurate (and computationally
intensive) pricing calculators often qualifies as refining within the margin of error.

Exposure calculation

MEASURING AND MARKING COUNTERPARTY RISK

and the final closing out of trades. A typical, conservative, close-out period is two weeks.

Model validation and control

Applications of exposure modeling

The most important uses of PFE models are:

PART III: ADVANCES IN ASSET/LIABILITY MANAGEMENT

Market valuation of credit exposures

Risk premiums

MEASURING AND MARKING COUNTERPARTY RISK

Mean* exposure times mean* loss rate

The total market value V(t) of default risk during the t-th future time period (say, a future
calendar quarter) is computed by the following steps.

1. Calculate EE*(t), the risk-neutral expected exposure for period t, that is, the average of

PART III: ADVANCES IN ASSET/LIABILITY MANAGEMENT

General Monte Carlo approach

The algorithm is described in simple illustrative terms, and not in a complete and computationally
efficient manner, as follows.

be simulated if uncertain.

A. This difference V(B)–V(A) can be positive or negative.
Example

PART III: ADVANCES IN ASSET/LIABILITY MANAGEMENT

General remarks on credit adjustments

For example, consider an interest rate swap between an outside customer Z, and one of
two possible dealers, Gilt, rated AAA, and Silver, rated BBB. Suppose that Z, rated AA,

MEASURING AND MARKING COUNTERPARTY RISK

Conclusion

The traditional potential-exposure framework discussed in the first part of this chapter
takes a static buy-and-hold view of counterparty risks, without incorporating the possibility of
dynamic hedging of liquid credit risks. As the liquidity and completeness of the credit derivatives
market continues to grow, more and more counterparty risks will become hedgeable.
Static potential exposure measures will be superseded by Value-at-Risk (VaR) and stress limits
similar to those currently used for other liquid market risks (such as those inherent in interest
rates and currencies). Some firms have adopted internal credit risk hedging via desks whose
purpose is to provide credit protection, at a transfer price, to other desks within the firm and
then to choose how much of the firm’s net exposure to each counterparty is to be traded to outside
counterparties. More decentralized firms have desk-by-desk hedging of credit risks.

It seems crucial that regulators appreciate this transformation. In particular, the framework
used to assess counterparty risk should evolve pari passu with the possibilities of risk
management.

The process of transformation of the static, buy-and-hold perception of counterparty risk
into dynamic hedging programs is irreversible.

PART III: ADVANCES IN ASSET/LIABILITY MANAGEMENT

Bibliography

Canabarro, E., E. Picoult, and T. Wilde (2003), ‘Analysing counterparty risk’, Risk Magazine,
Vol. 16, No. 19, pp. 117–122 (September).

Das, S., and R. Sundaram (1999), ‘Of Smiles and Smirks, A Term Structure Perspective’,
Journal of Financial and Quantitative Analysis, Vol. 34, pp. 211–239.

Duffie, D. (1999), ‘Credit swap valuation’, Financial Analysts Journal, January–February,
1999, pp. 73–87.

Duffie, D., and M. Huang (1996), ‘Swap rates and credit quality’, Journal of Finance, Vol.
51, pp. 921–949.

Duffie, D., and K. Singleton (2003), Credit Risk, Princeton, Princeton University Press.

Hull, J. (2000), Options, Futures, and Other Derivative Securities, 4th edition, Englewood
Cliffs, NJ, Prentice-Hall.

Kealhofer, S. (2003), ‘Quantifying credit risk I: Default prediction’, Financial Analysts
Journal, January–February, pp. 30–44.

1
See published surveys on ISDA’s website, www.isda.org.