Understanding Systemic Risk in Global Financial Markets

CHAPTER 11Counterparty Credit Risk

INTRODUCTION

This chapter explores counterparty credit risk in depth. We first learn about OTC derivatives and why they are a source of counterparty credit risk. We then learn how counterparty credit risk is managed through collateral, netting, and central counterparties. This chapter also explores counterparty credit risk as a source of systemic risk.

After you read this chapter you will be able to:

• Describe derivative securities, including forwards, futures, options, and swaps.
• Understand the counterparty exposure associated with a derivative security.
• Explain the concepts of gross assets and net assets.
• Understand how collateral, netting, and central counterparties are used to manage counterparty credit risk.
• Distinguish between bilateral netting and multilateral netting.
• Understand why counterparty credit risk is perceived as a source of systemic risk.

OVERVIEW OF DERIVATIVE SECURITIES

A derivative security is an agreement between two counterparties to transact in the future in which the counterparties' profit or loss is a function of the value of an underlying asset. Derivative securities may trade on a derivatives exchange or through an over-the-counter (OTC) derivatives market. An OTC derivatives market is a market where trading takes place through networks of dealers that are employed by financial institutions, and does not take place on an exchange.

Broadly, there are three varieties of derivative securities:

• Forwards/futures ...