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

4.4 Conclusion

In this chapter, we have described the primary ways of mitigating counterparty risk via exposure. Closeout netting is a crucial way to control credit exposure by being legally able to offset transactions with positive and negative mark-to-market values in the event a counterparty does default. Reset features allow the periodic resetting of an exposure. Early termination events allow the termination of a transaction to mitigate an exposure combined with a deterioration of the credit quality of a counterparty, possibly linked to some event such as a credit ratings downgrade. Compression reduces gross notional and therefore also the associated net exposure.

In the next chapter, we discuss the use of collateral, which is the other main method for reducing credit exposure.

Notes

1. Note that the hedge may, in fact, be a series of trades.

2. The calculations made by the surviving party may be disputed later via litigation. However, the prospect of a valuation dispute and an uncertain recovery value does not affect the ability of the surviving party to immediately terminate and replace the contracts with a different counterparty.

3. This in turn should incorporate the value of any break clause in the replacement contract and so on to infinity.

4. They may be based on as little as a 1-notch downgrade in a credit rating or a more substantial downgrade, for example to sub-investment grade status.

5. By this point, the counterparty is usually in severe financial distress and ...