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

8.1 Credit Exposure

8.1.1 Definition

A defining feature of counterparty risk arises from the asymmetry of potential losses with respect to the value¹ of the underlying transaction(s). In the event that a counterparty has defaulted, an institution may closeout the relevant contract(s) and cease any future contractual payments. Following this, they may determine the net amount owing between them and their counterparty and take into account any collateral that may have been posted. Note that collateral may be held to reduce exposure but any posted collateral may have the effect of increasing exposure.

Once the above steps have been followed, there is a question of whether the net amount is positive or negative. The main defining characteristic of credit exposure is related to whether the effective value of the contracts (including collateral) is positive (in an institution's favour) or negative (against them), as illustrated in Figure 8.1.

• Negative value. In this case, an institution is in debt to its counterparty and is still legally obliged to settle this amount (they cannot walk away from the transaction or transactions except in specific cases – see Section 4.3.3). Hence, from a valuation perspective, the position appears essentially unchanged. An institution does not gain or lose from their counterparty's default in this case.
• Positive value. When a counterparty defaults, they will be unable to undertake future commitments and hence an institution will have a claim on the positive ...