Counterparty Credit Risk: The new challenge for global financial markets

Chapter 2

Defining Counterparty Credit Risk

“An expert is a person who has made all the mistakes that can be made in a very narrow field.”

Niels Bohr (1885–1962)

2.1 INTRODUCING COUNTERPARTY RISK

“… probably the single most important variable in determining whether and with what speed financial disturbances become financial shocks, with potential systemic traits”

Counterparty Risk Management Policy Group (2005)

Counterparty risk is in one sense a specific form of credit risk, yet its significance is far greater than such a description might suggest. The understanding of counterparty risk requires knowledge of all financial risks, such as market risk, credit risk, operational risk and liquidity risk. Furthermore, the interaction of different financial risks is critical in defining the nature of counterparty risk. As has been shown in the market events of the last few years, counterparty risk is the most complex form of credit risk with systemic traits and the potential to cause, catalyse or magnify serious disturbances in the financial markets. Hence, the need to understand, quantify and manage counterparty risk is crucial. Without this, the future health, development and growth of derivatives products and financial markets in general will be greatly compromised.

2.1.1 Origins of counterparty risk

All corporate treasurers will generate substantial exposures to banks through deposits and investments as well as via derivatives products. Whilst they will try to have an even spread ...