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

4.1 Introduction

4.1.1 The Origins of Counterparty Risk

The classic counterparty credit risk problem is illustrated in Figure 4.1, supposing an institution executes a trade with counterparty A and hedges this with counterparty B.¹ For example, the institution could be a bank providing an OTC derivative trade to a customer (A) and hedging it with another bank (B). In this situation, the institution has no volatility of their overall profit and loss (PnL) and, consequently, no market risk. However, they do have counterparty risk to both counterparties A and B since, if either were to default, then this would leave exposure to the other side of the trade.

Figure 4.1 Illustration of the typical situation in which counterparty risk arises.

4.1.2 The ISDA Master Agreement

The International Swaps and Derivatives Association (ISDA) is a trade organisation for OTC derivatives practitioners. The ISDA Master Agreement is a bilateral framework, which contains terms and conditions to govern transactions between parties. It is designed to eliminate legal uncertainties and to provide mechanisms for mitigating counterparty risk. It specifies the general terms of the agreement between parties with respect to general questions such as netting, collateral, definition of default and other termination events. Multiple transactions can be subsumed under this general Master Agreement to form a single ...