Financial Risk Management: A Practitioner's Guide to Managing Market and Credit Risk, 2nd Edition

CHAPTER 14

Counterparty Credit Risk

Counterparty credit risk management arising from derivative contracts is an extremely important piece of the management of credit risk for reasons discussed in Section 14.1. Since the first edition of this book was published, the first full-length book treatment of counterparty credit risk, written by one of the leading practitioners in this field, Gregory (2010), has appeared. I will be making frequent reference to this book in what follows and will provide several suggestions for further reading in Gregory that will provide greater detail and examples for points I will raise.

14.1 OVERVIEW

For credit risk, derivatives represent a two-edged sword. On the one hand they have been valuable tools in reducing credit exposure, but on the other hand the use of derivatives leads to the buildup of credit exposure. The hope is that exposure reduction outweighs exposure buildup, but, without careful management, the full potential for credit exposure reduction by derivatives use will not be achieved.

When financial derivatives markets first began to grow in the 1970s, the growth was primarily in currency and interest rate derivatives, and this remains the largest use to the current day (over 85 percent of the notional amount of contracts outstanding, according to figures from Tables 19 and 23A in the Bank for International Settlements' December 2011 Derivatives Statistics). One use of these derivatives was to take on market exposures that could previously ...