Counterparty Credit Risk and Credit Value Adjustment

Acknowledgements xvii List of Spreadsheets xix List of Appendices xxi SECTION I INTRODUCTION 1 1 Introduction 3 2 Background 9 2.1 Introduction 9 2.2 Financial risk 9 2.3 Value-at-Risk 11 2.4 The derivatives market 14 2.5 Counterparty risk in context 18 2.6 Summary 20 3 Defining Counterparty Credit Risk 21 3.1 Introducing counterparty credit risk 21 3.2 Components and terminology 30 3.3 Control and quantification 34 3.4 Summary 40 SECTION II MITIGATION OF COUNTERPARTY CREDIT RISK 41 4 Netting, Compression, Resets and Termination Features 45 4.1 Introduction 45 4.2 Netting 46 4.3 Termination features and trade compression 51 4.4 Conclusion 57 5 Collateral 59 5.1 Introduction 59 5.2 Collateral terms 64 5.3 Defining the amount of collateral 71 5.4 The risks of collateralisation 74 5.5 Summary 77 6 Default Remote Entities and the Too Big to Fail Problem 79 6.1 Introduction 79 6.2 Special purpose vehicles 82 6.3 Derivative product companies 82 6.4 Monolines and credit DPCs 84 6.5 Central counterparties 93 7 Central Counterparties 97 7.1 Centralised clearing 97 7.2 Logistics of central clearing 105 7.3 Analysis of the impact and benefits of CCPs 113 7.4 Conclusions 118 8 Credit Exposure 121 8.1 Credit exposure 121 8.2 Metrics for credit exposure 126 8.3 Factors driving credit exposure 130 8.4 Understanding the impact of netting on exposure 138 8.5 Credit exposure and collateral 143 8.6 Risk-neutral or real-world? 150 8.7 Summary 153 SECTION III CREDIT VALUE ADJUSTMENT 155 9 Quantifying Credit Exposure 157 9.1 Introduction 157 9.2 Methods for quantifying credit exposure 157 9.3 Monte Carlo methodology 159 9.4 Models for credit exposure 165 9.5 Netting examples 170 9.6 Allocating exposure 175 9.7 Exposure and collateral 185 9.8 Summary 195 10 Default Probability, Credit Spreads and Credit Derivatives 197 10.1 Default probability and recovery rates 197 10.2 Credit default swaps 211 10.3 Curve mapping 217 10.4 Portfolio credit derivatives 220 10.5 Summary 224 11 Portfolio Counterparty Credit Risk 225 11.1 Introduction 225 11.2 Double default 225 11.3 Credit portfolio losses 229 11.4 Summary 239 12 Credit Value Adjustment 241 12.1 Definition of CVA 242 12.2 CVA and exposure 246 12.3 Impact of default probability and recovery 250 12.4 Pricing new trades using CVA 252 12.5 CVAwith collateral 260 12.6 Summary 263 13 Debt Value Adjustment 265 13.1 DVA and counterparty risk 265 13.2 The DVA controversy 271 13.3 How to monetise DVA 274 13.4 Further DVA considerations 277 13.5 Summary 281 14 Funding and Valuation 283 14.1 Background 283 14.2 OIS discounting 285 14.3 Funding value adjustment 290 14.4 Optimisation of CVA, DVA and funding costs 299 14.5 Future trends 304 14.6 Summary 306 15 Wrong-Way Risk 307 15.1 Introduction 307 15.2 Overview of wrong-way risk 307 15.3 Portfolio wrong-way risk 314 15.4 Trade-level wrong-way risk 319 15.5 Wrong-way risk and credit derivatives 331 15.6 Summary 337 SECTION IV MANAGING COUNTERPARTY CREDIT RISK 339 16 Hedging Counterparty Risk 341 16.1 Background to CVA hedging 342 16.2 Components of CVA hedging 346 16.3 Exposure hedges 349 16.4 Credit hedges 354 16.5 Cross-dependency 357 16.6 The impact of DVA and collateral 362 16.7 Summary 368 17 Regulation and Capital Requirements 371 17.1 Introduction 371 17.2 Basel II 372 17.3 Exposure under Basel II 375 17.4 Basel III 384 17.5 Central counterparties 399 17.6 Summary 401 18 Managing CVA - The "CVA Desk" 403 18.1 Introduction 403 18.2 The role of a CVA desk 404 18.3 CVA charging 410 18.4 Technology 415 18.5 Practical hedging of CVA 419 18.6 Summary 425 19 The Future of Counterparty Risk 427 19.1 Key components 427 19.2 Key axes of development 430 19.3 The continuing challenge for global financial markets 432 References 435 Index 443