On August 9th evening, Dr. Dmitri Rubisov (Managing Director, BMO Capital Markets) walked through basic concepts and framework of Counterparty Credit Risk (CCR) with NHC audience.
The session began with the characterization of Credit Risk, which is the risk from losses due to defaults. The primary source of the credit risk is from loans done by investment and corporate banking; for trading book, the credit risk mainly comes from OTC transactions, also known as derivatives trading. All trades that have pending payments directly from a counterparty, are exposed to have Counterparty Credit Risk.
This raises the question: how can we measure the Counterparty Credit Risk? Dr. Rubisov answered this by introducing the main concept in CCR, i.e., the Potential Future Exposure (PFE), alias Replacement Risk or Deemed Risk. PFE is the maximum credit exposure calculated at some level of confidence (usually set at 95%) over a specified period of time. The credit exposure is based on the simulations of future market conditions and repricing of derivative trades. Dr. Rubisov then used an example of Interest Rate Swap to demonstrate the calculation of PFE.
PFE concept is very similar to VaR, as both of them are percentile numbers, yet VaR is a measurement of potential losses on portfolio and PFE is focused on potential gains. When calculating PFE, we assume that the counterparty has already been in default, and typically ignore any correlation between the market condition and probability of default. To account for the correlation between the customer credit status and the moneyness of transactions when it cannot be ignored, Dr. Rubisov then introduced the idea of Wrong Way Risk (WWR). WWR is prevailing in transactions like CDS and TRS.
Is there any way to perfectly hedge the counterparty credit risk?Unfortunately, the answer is no. However, there are various ways to significantly mitigate the risk:
ISDA – Netting. Under ISDA master agreement, the participant can net the termination values of both positive and negative transactions when the other counterparty defaults; while under no-net agreement, the exposure will be the sum of all positive PVs, as the negative exposure will be zero out.
ISDA CSA – Collateralization. Under CSA agreement, the in-the-money participant has the right to ask the other counterparty to post collateral to cover its positive MTM. Collateral usually comes in the form of liquid assets, including cash, sovereign or agency bonds and provincial bonds in Canada.
IM, VM and IA. The CCR can be significantly reduced by posting Initial Margins (IM) and Variation Margin (VM) in the margin account to cover the MTM plus the close-out variations on their portfolios. For OTC transactions with low quality client like hedge fund, bank can ask for Independent Amount (IA) upfront to mitigate risk.
The next step for CCR is the regulatory capital. The Basel proposal approved two approaches: Standardized Approach for Counterparty Credit Risk (SA-CCR) and Internal Model Method (IMM). Though SA-CCR method is a factor approach which is more conservative than the IMM approach, whether banks are willing to spend effort on developing their own internal model still reminds a question.
Written by Carolyn Tian
Carolyn graduated from the Master of Mathmatical Finance program at University of Toronto. She is currently working for counterparty credit risk production at BMO Financial Group.