# CHAPTER 2

# Supervisory Requirements and Expectations for Portfolio-Level Counterparty Credit Risk Measurement and Management

**Michael Jacobs Jr., PhD, CFA**^{1}

Pricewaterhouse Cooper Advisory LLP

## INTRODUCTION

A bank's *counterparty credit risk* (CCR) exposure quantifies how much money the counterparty might owe the bank in the event of default. The CCR quantity is broken down into *current exposure* (CE), which measures the exposure if the counterparty were to default today, and *potential exposure* (PE), which measures the potential increase in exposure that could occur between today and some time horizon in the future.

The time of default is typically modeled as a stochastic stopping time. As opposed to the known CE, the PE must be estimated, usually by simulation. First, the *expected positive exposure* (EPE) is computed by simulating a large number (on the order of 10^{2} to 10^{3}) of different paths for the various underlying future prices in the possible market environments, using a so-called regularized variance-covariance matrix. Then the system prices each of the derivative transactions on each path for each sample date,^{2} computes collateral call amounts based on relevant marked-to-market (MTM) calculations, applies the portfolio effects of netting and collateral, and aggregates exposure results to compute the average exposure along a term structure.

While an EPE may be a good indicator of the cost to replace a contract should the counterparty default, EPE is not helpful in the trade inception ...