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

5.5 Summary

In this chapter we have discussed in detail the use of collateral management in controlling credit exposure, which is a crucial method when trading involving large positions and/or relatively risky counterparties. We have described the mechanics of collateral management and the variables that determine how much collateral would be posted. The significant risks that arise from collateral use have also been considered.

Collateral management should be understood as a way to improve recovery in the event of a counterparty actually defaulting but it is certainly not a replacement for a proper ongoing assessment of credit quality and quantification of credit exposure. Furthermore, the use of collateral mitigates counterparty risk but can aggravate funding liquidity risk and create other financial risks.

In our description of risk mitigation we have now covered all the methods of reducing credit exposure. We now move to assessing how counterparty risk can be reduced via the default probability of a counterparty.

Notes

1. 92% of collateral agreements in use are ISDA agreements. Source: ISDA Margin Survey 2010.

2. Note that a threshold can be zero, in which case this is not an issue. However, even many interbank CSAs have non-zero thresholds.

3. The purpose of an independent amount is to mitigate this risk by providing a buffer.

4. In addition, the wrong-way risk embedded in credit derivatives may be driving this aspect although it is not clear whether collateral strongly mitigates ...