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

11.4 Summary

In this chapter we have described the basics of modelling credit portfolio risk and therefore addressed the issue of defining the default of two or more counterparties. Initially, the two-name case has been described and the efficiency of a CDS product in hedging counterparty risk has been assessed. Following this, the multiple-name case has been considered, including the impact of random (derivatives) exposures on the distribution of losses. The quantitative foundations for the use of “loan equivalents” based on EPE have been described. We show that, whilst in most cases EPE provides a good approximation of the risk at the portfolio level, there are cases such as credit derivatives where this is clearly not the case. In Chapter 17 we will discuss portfolio aspects in relation to the regulatory treatment of counterparty risk. We will also describe in more detail how the concept of loan equivalents and the alpha factor has been incorporated into regulatory capital rules within Basel II.

Notes

1. Even then, there is likely to be some systemic scenario (such as a downturn in the sector) that could lead both counterparties to default.

2. Meaning simply that default can either occur or not, so there are just two (rather than a continuum of) states to consider. The nature of default, as in this two-state process, means that the application of classical statistical concepts such as correlation is not straightforward.

3. Although there is a clear link between this simple approach ...