Financial Risk Management: Applications in Market, Credit, Asset and Liability Management and Firmwide Risk

Chapter 5Counterparty Credit Risk

Counterparty credit risk measures the replacement cost of a derivative contract should the counterparty default anytime during the life term before honoring the contractual cash flows. In an over-the-counter (OTC) derivative transaction the mark-to-market value is not constant, and hence the credit exposure changes in response to market factors at each future date. Counterparty credit risk is therefore measured as an exposure profile over the remaining life of the transaction. The actual profile depends on the assumption of market factors and deal specifics, such as deal-aging. Since the exposure is from a bilateral contact, the mark to market of the exposure can be positive or negative. However, there is only counterparty credit risk if the exposure is positive.

Several exposure measures are used by banks in practice. For example, the expected exposure profile is frequently used for pricing counterparty credit risk and in Basel regulatory default risk charges. However, banks also calculate potential future exposures that represent a maximum amount of exposure at a high level of confidence, say , at any future date. The collection of such exposure values across time is often referred to as potential future exposure profile or peak exposure profile at a given confidence level. The peak exposure is frequently used to manage counterparty limits in ...