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

10.5 Summary

This chapter has been concerned with an overview of default probability, credit spreads and credit derivatives. We have described default probability, estimation methods and the differences between real and risk-neutral default probabilities. The impact of recovery rates has also been discussed. Detail necessary to calculate risk-neutral default probabilities from credit spreads, which will be required in CVA calculations later, has been given. We have described the important credit derivatives instruments that will be essential for discussing wrong-way risk (Chapter 15) and hedging (Chapter 16). Finally, we have discussed curve-mapping procedures that are an important component of CVA quantification.

In Chapter 11, we consider the nature of portfolio counterparty risk, where we focus on the joint default probabilities of many counterparties at the same time.

Notes

1. The sum of the first six numbers in the bottom row of Table 10.1, which represent the total probability of an upgrade.

2. Other assumptions are that in the data, only a maximum of one credit rating move was experienced in a given year and that credit ratings have no “memory” – e.g., a given rating that has been upgraded or downgraded recently is not different from the same rating not subject to such a move.

3. A key point to consider is that poor credit quality firms have default probabilities concentrated in the short term, not necessarily because their credit quality is expected to improve over time ...