P2.T6. Credit Risk Measurement & Management Jon Gregory, The xva Challenge: Counterparty Credit Risk, Funding, Collateral, and Capital Bionic Turtle FRM Study Notes Sample By David Harper, CFA FRM CIPM and Deepa Raju www.bionicturtle.com
Gregory, Chapter 4: Counterparty Risk DESCRIBE COUNTERPARTY RISK AND DIFFERENTIATE IT FROM LENDING RISK.... 3 DESCRIBE TRANSACTIONS THAT CARRY COUNTERPARTY RISK AND EXPLAIN HOW COUNTERPARTY RISK CAN ARISE IN EACH TRANSACTION.... 4 IDENTIFY AND DESCRIBE INSTITUTIONS THAT TAKE ON SIGNIFICANT COUNTERPARTY RISK.... 6 2
Gregory, Chapter 4: Counterparty Risk Describe counterparty risk and differentiate it from lending risk. Describe transactions that carry counterparty risk and explain how counterparty risk can arise in each transaction. Identify and describe institutions that take on significant counterparty risk. Describe credit exposure, credit migration, recovery, mark-to-market, replacement cost, default probability, loss given default, and the recovery rate. Identify and describe the different ways institutions can quantify, manage and mitigate counterparty risk. Describe counterparty risk and differentiate it from lending risk. Lending risk is the traditional credit risk: one party borrows and owes money to another party but may fail to pay some (or all) of the amount owed due to insolvency. Lending risk has two features: The notional amount at risk at any time during the lending period is usually known with a degree of certainty. Market variables such as interest rates will typically create only moderate uncertainty over the amount owed. For example, in buying a bond, the notional amount at risk for the life of the bond is close to par. A repayment mortgage will amortize over time (the notional drops due to the repayments) but one can predict with good accuracy the outstanding balance at some future date. A loan or credit card may have a certain maximum usage facility, which may reasonably be assumed fully drawn for the purpose of credit risk. Only one party takes lending risk. A bondholder takes considerable credit risk, but an issuer of a bond does not face a loss if the buyer of the bond defaults. With counterparty risk, as with all credit risk, the cause of a loss is the obligor being unable or unwilling to meet contractual obligations. However, two aspects differentiate contracts with counterparty risk from traditional credit risk: The value of the contract in the future is uncertain in most cases significantly so. The MTM value of a derivative at a potential default date will be the net value of all future cashflows required under that contract. This future value can be positive or negative and is typically highly uncertain (as seen from today). Since the value of the contract can be positive or negative, counterparty risk is typically bilateral. In other words, each counterparty in a derivatives transaction has risk to the other. The primary distinguishing feature of counterparty risk compared with other forms of credit risk is that the value of the underlying contract in the future is uncertain, both in magnitude and in sign! Jon Gregory 3
Describe transactions that carry counterparty risk and explain how counterparty risk can arise in each transaction. Counterparty risk typically arises from two classes of financial products: over the counter (OTC) derivatives and securities financing transactions (including repos): OTC derivatives: Due to the need for customization (lower basis risk), a much greater notional amount of derivatives are traded OTC. OTC derivatives trade bilaterally between two parties with each assuming counterparty risk to the other. o Interest rate products (e.g., interest rate swaps) are majority of outstanding notional. o The exposure of derivative products is substantially smaller than their gross notional. For example, the total market value of interest rate contracts is only 3.1% of the total notional outstanding (as of December 2010) Repos: Many institutions use standard sale and repurchase agreements ( repos ) as a liquidity management tool to swap cash against collateral for a pre-defined period. The lender of cash is paid a repo rate (i.e., the interest rate on the transaction plus any counterparty risk charge). The collateral tends to be liquid securities, of stable value, with a haircut applied to mitigate the counterparty risk. Contrast their counterparty risk with exchange-traded derivatives: When trading a futures contract (a typical exchange-traded derivative), the counterparty is the actual exchange. The exchange guarantees the contract performance and mitigates, if not eliminates, counterparty risk (a clearing role normally is attached to the exchange). Derivatives traded on an exchange are often viewed as having no counterparty risk since the only concern is the solvency of the exchange itself. Settlement and pre-settlement risk A derivatives portfolio contains a number of settlements equal to multiples of the total number of transactions; for example, a swap contract will have a number of settlement dates as cashflows are exchanged periodically. Counterparty risk is mainly associated with pre-settlement risk: the risk of counterparty default prior to expiration (settlement) of the contract. However, we should also consider settlement risk; i.e., the risk of counterparty default during settlement process. Pre-settlement risk (a.k.a., counterparty risk): This is the risk that a counterparty will default prior to the final settlement of the transaction (at expiration). Counterparty risk usually refers to this risk. Settlement risk. This arises at final settlement if there are timing differences between when each party performs on its obligations under the contract. For Example: Suppose an institution enters into a forward FX contract to exchange 1m for $1.1m at a specified date in the future. The settlement risk exposes the institution to a substantial loss of $1.1m, which could arise if 1m was paid but the $1.1m was not received. However, this only occurs for a single day on expiry of the FX forward. This type of crosscurrency settlement risk is also called Herstatt risk. Pre-settlement risk (counterparty risk) exposes the institution to just the difference in market value between the dollar and Euro payments. If the foreign exchange rate moved from 1.1 to 1.15, this would translate into a loss of $50,000, but this could occur at any time during the life of the contract. 4
The difference between pre-settlement and settlement risk is illustrated in Figure 4.1. Unlike counterparty risk, settlement risk is characterized by a very large exposure potentially, 100% of the notional of the transaction. While settlement risk gives rise to much larger exposures, default prior to expiration of the contract is substantially more likely than default at the settlement date. However, settlement risk can be more complex when there is a substantial delivery period (for example, as in a commodity contract where one may be required to settle in cash against receiving a physical commodity over a specified time period). Whilst all derivatives technically have both settlement and pre-settlement risk, the balance between the two will be different depending on the contract. Spot contracts have mainly settlement risk whilst long-dated swaps have mainly pre-settlement (counterparty) risk. Furthermore, various types of netting provide mitigation against settlement and presettlement risks. Settlement risk is a major consideration in FX markets, where the settlement of a contract involves a payment of one currency against receiving the other. Settlement risk typically occurs for only a small amount of time (often just days, or even hours). To measure the period of risk to a high degree of accuracy would mean taking into account the contractual payment dates, the time zones involved and the time it takes for the bank to perform its reconciliations across accounts in different currencies. Any failed trades should also continue to count against settlement exposure until the trade actually settles. Institutions typically set separate settlement risk limits and measure exposure against this limit rather than including settlement risk in the assessment of counterparty risk. It may be possible to mitigate settlement risk, for example by insisting on receiving cash before transferring securities. Recent developments in collateral posting have the potential to increase currency settlement risk. The standard CSA, the regulatory collateral requirements and central clearing mandate incentivize or require cash collateral posting in the currency of a transaction. These potentially create more settlement risk, and associated liquidity problems, as parties have to post and receive large cash payment in silos across multi-currency portfolios. 5
Identify and describe institutions that take on significant counterparty risk. The range of institutions that take significant counterparty risk has changed dramatically over recent years. In general, these institutions include the following: Large derivatives player A large bank, often known as a dealer with many OTC derivatives trades on books. Trades with many clients and large players Coverage of all or many different asset classes (interest rate, foreign exchange, equity, commodities, credit derivatives) Will post collateral against positions Medium derivatives player A smaller bank or other financial institution; e.g., hedge fund, pension fund Many OTC derivatives trades on books Trades with relatively large number of clients Will cover several asset classes although may not be active in all of them (may, for example, not trade credit derivatives or commodities and will probably not deal with the more exotic derivatives) Will probably post collateral against positions with some exceptions Small derivatives player A large corporate or sovereign with significant derivatives requirements; e.g., for hedging needs or investment) or a small financial institution Will have a few OTC derivatives trades on their books Will trade with potentially only a few different counterparties May specialize in a single asset class (e.g., some corporates trade only foreign exchange products, a mining company may trade only commodity forwards, a pension fund may only be active in interest rate and inflation products); Often unable to commit to posting collateral or will post illiquid collateral. Third parties For example, offer collateral management, software, trade compression and clearing services. They allow market participants to reduce counterparty risk, the risks associated with counterparty risk (such as legal) and improve overall operational efficiency with respect to these aspects 6
The Global Financial Crisis (GFC) exposed latent counterparty risk Historically, large derivatives players had stronger credit quality than other participants. However, some small players (e.g., sovereigns, insurance companies) had AAA-rated credit quality and used this to obtain favorable terms such as one-way collateral agreements. Prior to 2007 (the onset of the global financial crisis), much counterparty risk was essentially ignored because large derivatives players or AAA-rated entities were assumed default free: the credit spreads of large, highly-rated financial institutions was just a few basis points per annum. However, the presumption of little counterparty risk was revealed to be a myth when the reality of unilateral and bilateral counterparty risk was recognized. Currently, all institutions facing counterparty risk must take it seriously and build their abilities in quantification, pricing and hedging aspects. 7