It is important for an institution to control the counterparty risk that they face. This must recognise the fact that counterparty risk varies substantially depending on aspects such as the transaction and counterparty in question. In addition, it is important to give the correct benefit arising from the many risk mitigants (such as netting and collateral) that may be relevant. Control of counterparty risk has been traditionally the purpose of credit limits, used by most banks for well over a decade.
However, credit limits only limit counterparty risk and, whilst this is clearly the first line of defence, there is also a need to correctly quantify and ensure an institution is being correctly compensated for the counterparty risk they take. This is achieved via credit value adjustment (CVA), which has been used increasingly in recent years as a means of putting a value or price on the counterparty risk faced by an institution.
An institution is faced with counterparty risk from many counterparties and must control the portfolio impact and link this to capital requirements, regulatory or economic. Finally, the hedging of a counterparty must also be considered. Let us examine these components and how they fit together.
Let us consider the first and most basic use of exposure, which is as a means to control the amount of risk to a given counterparty over time. The basic idea of diversification is to avoid putting all your eggs in one ...