Counterparty Credit Risk and Credit Value Adjustment
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Content
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
