Counterparty Credit Risk and Credit Value Adjustment: A Continuing Challenge for Global Financial Markets, 2nd Edition

2.1 Introduction

Financial risk is broken down into a number of different types, one of which is counterparty risk. Counterparty risk is arguably the most complex financial risk to deal with since it is driven by the intersection of different risk types (for example, market and credit) and is highly sensitive to systemic traits, such as the failure of large institutions. Counterparty risk also mainly involves the most complex financial instruments, derivatives. Derivatives can be extremely powerful and useful, have aided the growth of global financial markets and have aided economic growth. However, as almost every average person now knows, derivatives can be highly toxic and cause massive losses and financial catastrophes if misused.

In this chapter, we review some of the background to counterparty risk and discuss other forms of financial risk. Counterparty risk should be considered and understood in the context of other financial risks, which we briefly review first. We also discuss the value-at-risk (VAR) concept, which is similar to PFE (potential future exposure), used to assess counterparty risk.