Chapter 10

Porfolio Models and Economic Capital

“The policy of being too cautious is the greatest risk of all.”

Jawaharlal Nehru (1889–1964)

10.1 INTRODUCTION

So far, all considerations of counterparty risk have been made at the level of a single counterparty. This involves combining exposure, default probability, recovery and including all risk mitigation methods within a given netting set. The concept of a netting set can be quite complex, with many different trades covered and detailed aspects such as collateral agreements to consider. Nevertheless, a netting set applies only for a single counterparty (except in the case of multilateral netting discussed in Chapter 14). We have also discussed the pricing and hedging of counterparty risk mainly in relation to an individual counterparty.

The final component in quantifying and managing counterparty risk will be to introduce portfolio level aspects, which will require consideratio n of the risk posed by two or more counterparties. Even the smallest users of derivatives will typically trade with several counterparties, whilst many financial institutions will have hundreds or even thousands of counterpa rties to consider. Hence, understanding the interactions between these individual counterparty risks at a portfolio level is necessary.

Portfolio assessment of counterparty risk is critical since an institut ion must be prepared for the possibility that a relatively large number of their counterparties may default. Whilst this number ...

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