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

8.5 Credit Exposure and Collateral

We now describe the key components in understanding the impact of collateral on credit exposure. Collateral typically reduces exposure but there are many (sometimes subtle) points that must be considered in order to assess properly the true extent of any risk reduction. To account properly for the real impact of collateral, parameters such as thresholds and minimum transfer amounts must be properly understood and represented appropriately. Furthermore, the “margin period of risk” must be carefully analysed to determine the true period of risk with respect to collateral transfer.

In addition to reducing it, collateral transforms counterparty risk into other risks, which must be thoroughly appreciated. Most notably, collateral leads to operational risk, legal risk and liquidity risk. Effective collateral management is counterproductive unless these risks are well understood and properly managed. We will highlight these risks in this section, although the reader is also referred to a more comprehensive treatment of the liquidity risks that can arise due to the use of collateral in Chapter 14.

Collateralisation of credit exposure can substantially reduce counterparty risk but to quantify the extent of the risk mitigation is not trivial and requires many, sometimes subjective, assumptions. To the extent that collateral is not a perfect form of risk mitigation, there are three considerations, which are illustrated in Figure 8.25. Firstly, there is a ...