Counterparty Credit Risk

Transcription

1 Counterparty Credit Risk The New Challenge for Global Financial Markets Jon Gregory ) WILEY A John Wiley and Sons, Ltd, Publication

2 Acknowledgements List of Spreadsheets List of Abbreviations Introduction XVll xviii xix xxi 1 Setting the Scene 1.1 Financial risk management Market risk Liquidity risk Operational risk Credit risk Value-at-risk Disadvantages of value-at-risk 1.2 The failure of models, i Why models? Good model, bad model / 1.3 The derivatives market What is a derivative? Market structure 1.4 Risks of derivatives Too big to fail Systemic risk Compensation culture Credit derivatives 1.5 Counterparty risk in context 1.5.1, What is counterparty risk? Mitigation of counterparty risk Counterparty risk and integration of risk types Counterparty risk and today's derivatives market '

3 Defining Counterparty Credit Risk 2.1 Introducing counterparty risk Origins of counterparty risk Repos Exchange-traded derivatives OTC derivatives Counterparty risk Counterparty risk versus lending risk Mitigating counterparty risk Counterparty risk players 2.2 Components and terminology Credit exposure Default probability and credit migration Recovery Mark-to-market Replacement cost Exposure Exposure as a short option position Potential future exposure (PFE) 2.3 Controlling counterparty credit risk Trading with high-quality counterparties Cross-product netting Close-out Collateralisation Walkaway features Monolines Diversification of counterparty risk Exchanges and centralised clearing houses 2.4 Quantifying counterparty risk Credit lines Pricing counterparty risk Hedging counterparty risk Capital requirements and counterparty risk 2.5 Metrics for credit exposure Expected MtM Expected exposure Potential future exposure EE and PFE for a normal distribution Overview of exposure metrics Expected positive exposure Effective EPE Maximum PFE 2.6 Summary Appendix 2.A Characterising exposure for a normal distribution

4 3 Mitigating Counterparty Credit Risk 3.1 Introduction Default-remote entities Two-way or one-way agreements Standardisation High-quality counterparties Special purpose vehicles Central counterparties Termination and walkaway features Netting Netting Collateral Termination events Additional termination events Walkaway features and close-out Close-out Payment and close-out netting The need for close-out netting The birth of netting Netting agreements The ISDA Master Agreement Product coverage Netting and exposure Advantages and disadvantages of netting Multilateral netting and exposure Negativity of MtM Impact of correlation Negative MtM of a netting set Positive MtM of a netting set The basics of collateralisation Analogy with mortgages Setting up a collateral agreement Valuation agent Types of collateral Coverage of collateralisation Disputes and reconciliations The mechanics of collateralisation , Linkage of collateral parameters to credit quality Margin call frequency Threshold Independent amount Minimum transfer amount Rounding Haircuts

5 3.7.8 Coupons and interest payments Substitution, reuse of collateral and rehypothecation Call-and-return example Is risk mitigation always a good thing? ' Summary 74 Appendix 3.A EE of independent normal variables 74 Quantifying Counterparty Credit Exposure, I Quantifying credit exposure Mark-to-market + add-ons Semi-analytical methods Monte Carlo simulation Roll-off risk Typical credit exposures Loans, bonds and repos Swaps FX products Options Credit derivatives Payment frequencies Exercise dates Models for credit exposure Calibration Risk-neutral or real? Equities FX Commodities Credit spreads Interest rates Advanced models Model validation Correlations Netting Modelling netting Netting factor Examnles 4.5 Exposure contributions Marginal EE ' Simple two-trade marginal EE example Marginal EE and correlation General example, Summary 104 Appendix 4.A Semi-analytical formula for exposure of a forward contract 105 Appendix 4.B Computing marginal EE

6 Quantifying Counterparty Credit Exposure, II: The Impact of Collateral Introduction The impact of collateral on credit exposure Remargin period Potential future exposure with collateral Volatility of exposure Collateral volatility Correlation between collateral and exposure Modelling collateral Parameters Collateral logic Full collateralisation Parameters Scenarios Exposure distributions Simple approximation - idealised case Simple approximation - impact of minimum transfer amount Impact of threshold Simple approximation - impact of threshold Operational cost versus reduction of exposure The risks of collateralisation Operational risk Default risk FX risk Liquidity and liquidation risk Summary 125 Appendix 5.A Calculation of couateralised PFE (cash collateral) 125 Appendix 5.B Calculation of couateralised netted exposure with collateral value uncertainty 126 Appendix 5.C Mathematical treatment of a couateralised exposure 126 Overview of Credit Risk and Credit Derivatives Defaults, recovery rates, credit spreads and credit derivatives Default rates Recovery rates Credit spreads Credit derivatives Market growth and uses Credit default swaps (CDSs) Credit-linked notes ' Asset swaps Linkage between bonds, asset swaps and CDS premiums Contingent credit default swap (CCDS) Fixed and digital CDSs and recovery swaps 138

7 Credit default swaps Reference entity and obligation Credit events Settlement of CDS Cheapest-to-deliver option and restructuring Delivery squeeze CDS risks ISDA 2009, Big Bang Protocol, Small Bang Protocol and new trading conventions Estimating default probability Appendix 6.A Appendix 6.B Appendix 6.C Denning default probability Historical estimation Equity-based approaches Market-implied default probabilities Portfolio credit derivatives CDS index products Index tranches Super senior risk CoUateralised debt obligations CDO investors Rating of CDOs Summary Defining survival and default probabilities Pricing formulas for CDSs and risky bonds Pricing of index tranches Pricing Counterparty Credit Risk, I 7.1 Pricing counterparty risk Motivation Why pricing counterparty risk is not easy Credit value adjustment (unilateral) Practical CVA formula (no wrong-way risk) CVA as a spread CVA semi-analytical methods How to calculate the EE for CVA 7.2 Pricing new trades using CVA CVA formula with collateral CVA formula with netting Netting and trade size Marginal CVA Exotic products Path dependency 7.3 Bilateral counterparty risk Background Bilateral CVA '7.3.3 Example

8 7.3.4 BCVA formula from credit spread BCVA or CVA? BCVA and break clauses BCVA and unwinding trades Walkaway features Summary 191 Appendix 7.A Deriving the equation for credit value adjustment (CVA) 192 Appendix 7.B Approximation to the CVA formula in the case of no wrong-way risk 194 Appendix 7.C Approximation linking CVA formula to credit spread 195 Appendix 7.D Specific approximations to the CVA formula for individual instruments 195 Appendix 7.E Calculation of CVA increase in the presence of netting 197 Appendix 7.F Deriving the equation for bilateral credit value adjustment (BCVA) 197 Appendix 7.G Approximation linking CVA formula to credit spreads for bilateral CVA. 199 Appendix 7.H Deriving the equation for BCVA under the assumption of a bilateral walkaway clause 200 Pricing Counterparty Credit Risk, II: Wrong-way Risk Introduction Wrong-way risk ' Empirical evidence of wrong-way risk effects Right-way risk Examples of wrong-way risk trades Wrong-way risk and CVA Measuring wrong-way risk Correlation is not the same as dependence Simple example Forward trade example.' Foreign exchange example Comparison of wrong-way risk approaches Risky option position Wrong-way risk and bilateral counterparty risk Wrong-way risk and collateral Counterparty risk in CDSs CDS payoff under counterparty default Quantifying CVA for a CDS Buying CDS protection Selling CDS protection Bilateral CDS counterparty risk Counterparty risk in structured credit Overview Credit indices : Index tranches. 224

9 8.5.4 Super senior tranches Counterparty risk distribution across capital structure, Impact of upfront tranche payments Counterparty risk and gap risk Motivation TRS transactions ' Leveraged CLN Converting counterparty risk to gap risk Super senior risk The leveraged super senior (LSS) trade Monolines Credit derivatives products companies (CDPCs) The value of protection purchased from monolines and CDPCs ' Summary 238 Appendix 8.A Computing the EE of a typical forward exposure with correlation to a time of default 239 Appendix 8.B Formula for a risky option 240 Appendix 8.C Formula for pricing a CDS contract with counterparty risk 240 Appendix 8.D Pricing of a leveraged super senior tranche 242 Hedging Counterparty Risk Introduction Hedging and pricing Hedging a risky derivative position Traditional hedging of bonds, loans and repos Risk-neutral or real parameters? Futures prices and future spot prices Drift Volatility Correlation Components of CVA Recovery risk Basis risk CVA sensitivity to recovery Recovery swaps Static hedging Static CDS hedging of exposures Contingent credit default swaps (CCDSs) Dynamic credit hedging Credit delta Gamma Jump-to-default risk Credit hedging with indices 264

10 9.10 Exposure Hedging spot rates Spot rates and drift Volatility Spot rate sensitivity under volatility hedging Cross-dependency Cross-gamma and wrong-way risk Hedging wrong-way risk Monolines Hedging bilateral counterparty risk Impact of collateralisation on hedging Aggregation of sensitivities Summary 278 Appendix 9.A Example of calculation of CVA Greeks Portfolio Models and Economic Capital Introduction Joint default Double-default approach Merton-style approach Impact of correlation Impact on CCDS Distribution of losses Impact of random exposure Impact of correlated exposures Credit portfolio losses Loss distributions and unexpected loss Impact of correlation Default-only approaches The impact of stochastic exposure <' Impact of random exposure on unexpected loss The alpha factor Example of alpha correction Sensitivity analysis on the alpha factor Special cases of alpha Correlation of exposures Asymmetric exposure Wrong-way risk What is the correct value of alpha? Credit migration and mark-to-market The importance of mark-to-market Modelling credit migrations Marking-to-market loans Marking-to-market derivatives Example ' 303

11 Summary. 304 Appendix 10.A Credit portfolio model 305 Appendix 10.B Simple treatment of wrong-way risk Counterparty Risk, Regulation and Basel II Introduction The birth of Basel II Basel II Framework for fixed exposures Overview The advanced IRB approach ' Asset correlation Maturity factor Exposure at default and Basel II Current exposure method Standardised method Treatment of repo-style transactions Basel II internal model method Introduction Effective maturity Exposure at default Defining alpha Effective EPE for couateralised counterparties Basel II and double-default Background Double-default formula Double-default adjustment factor Accounting for double-default for derivatives Summary 327 Appendix 11.A Effective remaining maturity 328 Appendix 11.B The asset correlation and maturity adjustment formulas in the advanced IRB approach of Basel II 329 Appendix ll.c Netting and collateral treatment under the current exposure method (CEM) of Basel II 329 Appendix ll.d Definition of effective EPE 330 Appendix ll.e Double-default treatment of hedged exposures in Basel II Managing Counterparty Risk in a Financial Institution Introduction Counterparty risk in financial institutions Components Counterparty risk group Responsibilities ' Organisational structure Mechanics of pricing Default settlement Technology aspects 337

12 12.3 Insurance company or trading desk? Background Insurance approach Trading desk approach Profit centre or not? Finding the balance How to calculate credit charges Real or risk-neutral? Default probabilities Drift, volatility and correlations Mark-to-market Bilateral credit charges How to charge for counterparty risk Lookup tables Stand-alone pricing Pricing incorporating risk mitigants Allocation of CVA Summary Counterparty Risk of Default-remote Entities The triple-a counterparty The need for institutions with long-term views Derivatives product companies Monolines Credit derivatives products companies The value of monolines and CDPCs Moral hazard Rating agencies and triple-a entities Credit insurer simple example Suspension modes, downgrades and death spirals Termination mode and run-off The random leverage effect.' The future for credit insurers Summary 365 Appendix 13.A Simple model for a credit insurer 365 Appendix 13.B The valuation of credit insurer purchased protection The Role of a Central Counterparty Centralised clearing Background Systemic risk in the derivatives markets Historical background to CCPs Bilateral netting versus centralised clearing Novation :1.6 The operation of a CCP 374 V4.1.7 Impact of default of a CCP member 374

13 Initial margin Reserve funds and loss mutualisation 14.2 The viability of centralised clearing The advantage of centralised clearing ' The disadvantages of centralised clearing Risk homogeneity and asymmetric information Competition Market coverage of a CCP Central counterparties and credit derivatives Under what circumstances will a CCP work? 14.3 Conclusions 15 The Future of Counterparty Risk 15.1 A counterparty risk revolution? 15.2 Controlling credit exposure 15.3 Collateral management) ' 15.4 The too-big-to-fail concept 15.5 Credit value adjustment (CVA) 15.6 Hedging 15.7 Credit derivatives 15.8 Central counterparties 15.9 The overall challenge Glossary References Index