Counterparty Credit Risk and Credit Value Adjustment: A Continuing Challenge for Global Financial Markets -- Contents -- Acknowledgements -- List of Spreadsheets -- List of Appendices -- SECTION I: INTRODUCTION -- 1 Introduction -- 2 Background -- 2.1 Introduction -- 2.2 Financial risk -- 2.2.1 Market risk -- 2.2.2 Credit risk -- 2.2.3 Liquidity risk -- 2.2.4 Operational risk -- 2.2.5 Integration of risk types -- 2.3 Value-at-Risk -- 2.3.1 Definition -- 2.3.2 The dangers of VAR -- 2.3.3 Models -- 2.3.4 Correlation and dependency -- 2.4 The derivatives market -- 2.4.1 Uses of derivatives -- 2.4.2 Exchange-traded and OTC derivatives -- 2.4.3 Risks of derivatives -- 2.4.4 Too big to fail and systemic risk -- 2.4.5 Credit derivatives -- 2.5 Counterparty risk in context -- 2.5.1 The rise of counterparty risk -- 2.5.2 Counterparty risk and CVA -- 2.5.3 Mitigating counterparty risk -- 2.5.4 Counterparty risk and central clearing -- 2.6 Summary -- 3 Defining Counterparty Credit Risk -- 3.1 Introducing counterparty credit risk -- 3.1.1 Counterparty risk versus lending risk -- 3.1.2 Settlement and pre-settlement risk -- 3.1.3 Exchange-traded derivatives -- 3.1.4 OTC-traded derivatives -- 3.1.5 Repos and securities lending -- 3.1.6 Mitigating counterparty risk -- 3.1.7 Counterparty risk players -- 3.2 Components and terminology -- 3.2.1 Credit exposure -- 3.2.2 Default probability, credit migration and credit spreads -- 3.2.3 Recovery and loss given default -- 3.2.4 Mark-to-market and replacement cost -- 3.2.5 Mitigating counterparty risk -- 3.3 Control and quantification -- 3.3.1 Credit limits -- 3.3.2 Credit value adjustment -- 3.3.3 CVA or credit limits? -- 3.3.4 What does CVA represent? -- 3.3.5 Hedging counterparty risk -- 3.3.6 Portfolio counterparty risk -- 3.4 Summary -- SECTION II: MITIGATION OF COUNTERPARTY CREDIT RISK.

4 Netting, Compression, Resets and Termination Features -- 4.1 Introduction -- 4.1.1 The origins of counterparty risk -- 4.1.2 The ISDA master agreement -- 4.2 Netting -- 4.2.1 Payment netting -- 4.2.2 The need for closeout netting -- 4.2.3 Closeout netting -- 4.2.4 Netting sets and subadditivity -- 4.2.5 The impact of netting -- 4.2.6 Product coverage -- 4.3 Termination features and trade compression -- 4.3.1 Reset agreements -- 4.3.2 Additional termination events -- 4.3.3 Walkaway features -- 4.3.4 Trade compression and multilateral netting -- 4.4 Conclusion -- 5 Collateral -- 5.1 Introduction -- 5.1.1 Rationale for collateral -- 5.1.2 Analogy with mortgages -- 5.1.3 The basics of collateralisation -- 5.1.4 Collateral usage -- 5.1.5 The credit support annex -- 5.1.6 Impact of collateral -- 5.2 Collateral terms -- 5.2.1 Valuation agent -- 5.2.2 Types of collateral -- 5.2.3 Coverage of collateralisation -- 5.2.4 Disputes and reconciliations -- 5.2.5 Margin call frequency -- 5.2.6 Haircuts -- 5.2.7 Coupons and interest payments -- 5.2.8 Substitution, funding costs and rehypothecation -- 5.3 Defining the amount of collateral -- 5.3.1 Types of CSA -- 5.3.2 Linkage of collateral parameters to credit quality -- 5.3.3 Threshold -- 5.3.4 Independent amount -- 5.3.5 Minimum transfer amount and rounding -- 5.4 The risks of collateralisation -- 5.4.1 Market risk and the margin period of risk -- 5.4.2 Operational risk -- 5.4.3 Liquidity risk -- 5.4.4 Funding liquidity risk -- 5.5 Summary -- 6 Default Remote Entities and the Too Big to Fail Problem -- 6.1 Introduction -- 6.1.1 Default remoteness and too big to fail -- 6.1.2 From OTC to exchange-traded -- 6.2 Special purpose vehicles -- 6.3 Derivative product companies -- 6.3.1 Standard DPCs -- 6.3.2 The decline of DPCs -- 6.4 Monolines and credit DPCs -- 6.4.1 Rationale -- 6.4.2 Monoline insurers.

6.4.3 Credit derivative product company -- 6.4.4 The massive monoline failure -- 6.4.5 Why the rating agencies got it wrong -- 6.4.6 A (very simple) quantitative analysis of monolines -- 6.5 Central counterparties -- 6.5.1 Introduction -- 6.5.2 Exchanges and clearing -- 6.5.3 Basics of central clearing -- 7 Central Counterparties -- 7.1 Centralised clearing -- 7.1.1 Systemic risk -- 7.1.2 The impact of the crisis -- 7.1.3 CCPs in perspective -- 7.1.4 Function of a CCP -- 7.1.5 Multilateral netting -- 7.1.6 How many CCPs? -- 7.1.7 Coverage of CCPs -- 7.2 Logistics of central clearing -- 7.2.1 Clearing members -- 7.2.2 Variation margin -- 7.2.3 Impact of default of a CCP member -- 7.2.4 Initial margin -- 7.2.5 Reserve funds, capital calls and loss mutualisation -- 7.2.6 Interoperability -- 7.2.7 Non-clearing members and end-users -- 7.3 Analysis of the impact and benefits of CCPs -- 7.3.1 The advantage of centralised clearing -- 7.3.2 Have CCPs failed before? -- 7.3.3 The impact of homogenisation -- 7.3.4 Will a CCP be allowed to fail? -- 7.3.5 Could OTC derivatives survive without CCPs? -- 7.3.6 Hurdles and challenges for the growth of the CCP market -- 7.4 Conclusions -- 8 Credit Exposure -- 8.1 Credit exposure -- 8.1.1 Definition -- 8.1.2 Bilateral exposure -- 8.1.3 The closeout amount -- 8.1.4 Exposure as a short option position -- 8.1.5 Future exposure -- 8.1.6 Comparison to value-at-risk -- 8.2 Metrics for credit exposure -- 8.2.1 Expected future value -- 8.2.2 Potential future exposure -- 8.2.3 Expected exposure -- 8.2.4 EE and PFE for a normal distribution -- 8.2.5 Maximum PFE -- 8.2.6 Expected positive exposure -- 8.2.7 Negative exposure -- 8.2.8 Effective expected positive exposure -- 8.3 Factors driving credit exposure -- 8.3.1 Loans and bonds -- 8.3.2 Future uncertainty -- 8.3.3 Periodic cash flows -- 8.3.4 Combination of profiles.

8.3.5 Optionality -- 8.3.6 Credit derivatives -- 8.4 Understanding the impact of netting on exposure -- 8.4.1 The impact of netting on future exposure -- 8.4.2 Netting and the impact of correlation -- 8.4.3 Netting and absolute value -- 8.5 Credit exposure and collateral -- 8.5.1 How much collateral? -- 8.5.2 Margin period of risk -- 8.5.3 Impact of collateral on exposure -- 8.5.4 Repos and overcollateralisation -- 8.6 Risk-neutral or real-world? -- 8.6.1 The importance of measure -- 8.6.2 Drift -- 8.6.3 Volatility -- 8.6.4 Correlations -- 8.6.5 Conclusion -- 8.7 Summary -- SECTION III: CREDIT VALUE ADJUSTMENT -- 9 Quantifying Credit Exposure -- 9.1 Introduction -- 9.2 Methods for quantifying credit exposure -- 9.2.1 Add-ons -- 9.2.2 Semi-analytical methods -- 9.2.3 Monte Carlo simulation -- 9.3 Monte Carlo methodology -- 9.3.1 Simulation model -- 9.3.2 Scenario generation -- 9.3.3 Revaluation -- 9.3.4 Aggregation -- 9.3.5 Post-processing -- 9.3.6 Extraction -- 9.4 Models for credit exposure -- 9.4.1 Risk-neutral vs real-world -- 9.4.2 Interest rates -- 9.4.3 FX and inflation -- 9.4.4 Commodities -- 9.4.5 Credit spreads -- 9.4.6 Equities -- 9.4.7 Correlations -- 9.4.8 Stochastic volatility -- 9.5 Netting examples -- 9.5.1 Examples -- 9.5.2 Exposure profiles -- 9.6 Allocating exposure -- 9.6.1 Simple two-trade, single-period example -- 9.6.2 Incremental exposure -- 9.6.3 Marginal exposure -- 9.6.4 Calculation of incremental and marginal exposure -- 9.7 Exposure and collateral -- 9.7.1 Collateral assumptions -- 9.7.2 Base case example -- 9.7.3 Impact of margin period of risk -- 9.7.4 Impact of threshold and independent amount -- 9.7.5 Are two-way CSAs always beneficial? -- 9.7.6 Non-cash collateral -- 9.8 Summary -- 10 Default Probability, Credit Spreads and Credit Derivatives -- 10.1 Default probability and recovery rates.

10.1.1 Defining default probability -- 10.1.2 Real and risk-neutral default probabilities -- 10.1.3 Estimating real default probabilities - historical data -- 10.1.4 Estimating real default probabilities - equity-based approaches -- 10.1.5 Estimating risk-neutral default probabilities -- 10.1.6 Comparison between real and risk-neutral default probabilities -- 10.1.7 Recovery rates -- 10.2 Credit default swaps -- 10.2.1 Basics of CDSs -- 10.2.2 Credit events -- 10.2.3 CDS settlement -- 10.2.4 The CDS-bond basis -- 10.2.5 Contingent credit default swaps -- 10.3 Curve mapping -- 10.3.1 Basics of mapping -- 10.3.2 Indices and classification -- 10.3.3 Curve shape -- 10.4 Portfolio credit derivatives -- 10.4.1 CDS index products -- 10.4.2 Index tranches -- 10.4.3 Super senior risk -- 10.4.4 Collateralised debt obligations -- 10.5 Summary -- 11 Portfolio Counterparty Credit Risk -- 11.1 Introduction -- 11.2 Double default -- 11.2.1 Joint default events -- 11.2.2 Merton-style approach -- 11.2.3 Impact of correlation -- 11.3 Credit portfolio losses -- 11.3.1 Simple two-name example -- 11.3.2 Loss distributions and unexpected loss -- 11.3.3 Example -- 11.3.4 The alpha factor -- 11.3.5 Alpha and wrong-way risk -- 11.4 Summary -- 12 Credit Value Adjustment -- 12.1 Definition of CVA -- 12.1.1 Why pricing CVA is not easy -- 12.1.2 CVA formula -- 12.1.3 CVA as a spread -- 12.2 CVA and exposure -- 12.2.1 Exposure and discounting -- 12.2.2 Risk-neutral exposure -- 12.2.3 CVA semi-analytical methods -- 12.3 Impact of default probability and recovery -- 12.3.1 Credit spread impact -- 12.3.2 Recovery impact -- 12.4 Pricing new trades using CVA -- 12.4.1 Netting and incremental CVA -- 12.4.2 Marginal CVA -- 12.4.3 CVA as a spread -- 12.4.4 Numerical issues -- 12.4.5 Path dependency, break clauses and exotics -- 12.5 CVAwith collateral.

12.5.1 Impact of margin period of risk.