Central Counterparties: Mandatory Central Clearing and Initial Margin Requirements for OTC Derivatives

Chapter 7

Counterparty Risk in OTC Derivatives

By definition, risk-takers often fail. So do morons. In practice it’s difficult to sort them out.

Scott Adams (1957–)

7.1 INTRODUCTION

This chapter is an introduction to relevant aspects of counterparty credit risk and other related topics such as credit value adjustment (CVA). We will review concepts such as credit exposure and valuation adjustments, and look at the impact of margin on counterparty risk. These topics are covered in more detail in other places (e.g. Pykhtin and Zhu 2007, Gregory 2012). The concept of funding value adjustment (FVA) can be seen as being related to counterparty risk reduction and will also be introduced.

7.1.1 Background

Traditionally, credit risk can generally be thought of as lending risk. One party owes an amount to another party and may fail to pay some or all of this due to insolvency. This can apply to loans, bonds, mortgages, credit cards and so on. Lending risk is based on relatively deterministic exposures (e.g. the size of a mortgage) and is unilateral (e.g. a mortgagor does not incur credit risk to a mortgagee).

Counterparty credit risk (often known just as counterparty risk) is the credit risk that the entity with whom one has entered into a financial contract (the counterparty to the contract) will fail to fulfil their side of the contractual agreement (e.g. they default). With counterparty risk, as with all credit risk, the cause of a loss is the obligor being unable or unwilling to meet ...