Measuring counterparty credit risk : an overview of the theory and practice

Abstract

The global over-the-counter derivatives market reached a staggering 14.5 trillion US dollars in gross market value at the end of December 2007. Although OTC derivatives are extremely useful and versatile in transferring risks, it appears to be a double-edged sword. For every derivative transaction concluded in the OTC market, there are two parties involved – each of which is exposed to the other defaulting on the agreed terms and conditions of the contract. Counterparty credit risk is defined as the loss that will be incurred in the event that a counterparty fails to honour its financial obligations. This dissertation provides an overview of counterparty credit risk measurement from a theoretical point of view and puts an emphasis on the demonstration of the current solutions used in practice to address this problem. The author applies a bottom up approach to the problem by defining counterparty credit risk exposure on a contract (single-trade) level and expands this definition on a step-by-step basis to incorporate portfolio effects, such as correlation among underlying market variables as well as credit risk mitigation techniques, such as netting and collateral agreements, in measuring counterparty credit risk exposure on a counterparty level. The author also discusses related concepts which impact counterparty credit risk such as wrong-way risk and proposes an enhancement to the framework introduced by Finger (2000) for incorporating wrong-way risk into existing measures of counterparty credit risk exposure. Finger‟s framework is enhanced by the introduction of a structural model approach which can be used in establishing a functional and intuitive relationship between the probability of default of the counterparty and the underlying market variable to the derivative contract under consideration. This approach is also applied to a typical South African situation through the use of Monte Carlo simulation. The topic of counterparty credit risk modelling is a very relevant topic in modern finance, especially since the advent of Basel 2 which this dissertation also touches on in terms of the applications of counterparty credit risk modelling and how this relates to the minimum regulatory capital requirements set by bank regulators. Copyright