Counterparty Credit Risk

Dr Jon Gregory is a consultant specialising in the area of counterparty risk. He started his career at Salomon Brothers (now Citigroup). From 1997 to 2005, he worked for BNP Paribas, initially developing the framework for the pricing and management of counterparty risk for the fixed income division and later being part of the rapid growth of the credit derivatives business. From 2005 to 2008, he was Global Head of Credit Analytics at Barclays Capital based in London. He has published many papers in the area of credit risk, recently looking at some of the complex counterparty risk issues in relation to the credit crisis. In 2001, he was co-author of the book Credit: The Complete Guide to Pricing, Hedging and Risk Management , short-listed for the Kulp-Wright Book Award for the most significant text in the field of risk management and insurance. Jon holds a PhD from Cambridge University.

Acknowledgements. List of Spreadsheets. List of Abbreviations. Introduction. 1 Setting the Scene. 1.1 Financial risk management. 1.2 The failure of models. 1.3 The derivatives market. 1.4 Risks of derivatives. 1.5 Counterparty risk in context. 2 Defining Counterparty Credit Risk. 2.1 Introducing counterparty risk. 2.2 Components and terminology. 2.3 Controlling counterparty credit risk. 2.4 Quantifying counterparty risk. 2.5 Metrics for credit exposure. 2.6 Summary. Appendix 2.A Characterising exposure for a normal distribution. 3 Mitigating Counterparty Credit Risk. 3.1 Introduction. 3.2 Default-remote entities. 3.3 Termination and walkaway features. 3.4 Netting and close-out. 3.5 Netting and exposure. 3.6 Collateral. 3.7 The mechanics of collateralisation. 3.8 Is risk mitigation always a good thing? 3.9 Summary. Appendix 3.A EE of independent normal variables. 4 Quantifying Counterparty Credit Exposure, I. 4.1 Quantifying credit exposure. 4.2 Typical credit exposures. 4.3 Models for credit exposure. 4.4 Netting. 4.5 Exposure contributions. 4.6 Summary. Appendix 4.A Semi-analytical formula for exposure of a forward contract. Appendix 4.B Computing marginal EE. 5 Quantifying Counterparty Credit Exposure, II: The Impact of Collateral. 5.1 Introduction. 5.2 The impact of collateral on credit exposure. 5.3 Modelling collateral. 5.4 Full collateralisation. 5.5 The risks of collateralisation. 5.6 Summary. Appendix 5.A Calculation of collateralised PFE (cash collateral). Appendix 5.B Calculation of collateralised netted exposure with collateral value uncertainty. Appendix 5.C Mathematical treatment of a collateralised exposure. 6 Overview of Credit Risk and Credit Derivatives. 6.1 Defaults, recovery rates, credit spreads and credit derivatives. 6.2 Credit derivatives. 6.3 Credit default swaps. 6.4 Estimating default probability. 6.5 Portfolio credit derivatives. Appendix 6.A Defining survival and default probabilities. Appendix 6.B Pricing formulas for CDSs and risky bonds. Appendix 6.C Pricing of index tranches. 7 Pricing Counterparty Credit Risk, I. 7.1 Pricing counterparty risk. 7.2 Pricing new trades using CVA. 7.3 Bilateral counterparty risk. 7.4 Summary. Appendix 7.A Deriving the equation for credit value adjustment (CVA). Appendix 7.B Approximation to the CVA formula in the case of no wrong-way risk. Appendix 7.C Approximation linking CVA formula to credit spread. Appendix 7.D Specific approximations to the CVA formula for individual instruments. Appendix 7.E Calculation of CVA increase in the presence of netting. Appendix 7.F Deriving the equation for bilateral credit value adjustment (BCVA). Appendix 7.G Approximation linking CVA formula to credit spreads for bilateral CVA. Appendix 7.H Deriving the equation for BCVA under the assumption of a bilateral walkaway clause. 8 Pricing Counterparty Credit Risk, II: Wrong-way Risk. 8.1 Introduction. 8.2 Wrong-way risk. 8.3 Measuring wrong-way risk. 8.4 Counterparty risk in CDSs. 8.5 Counterparty risk in structured credit. 8.6 Counterparty risk and gap risk. 8.7 Super senior risk. 8.8 Summary. Appendix 8.A Computing the EE of a typical forward exposure with correlation to a time of default. Appendix 8.B Formula for a risky option. Appendix 8.C Formula for pricing a CDS contract with counterparty risk. Appendix 8.D Pricing of a leveraged super senior tranche. 9 Hedging Counterparty Risk. 9.1 Introduction. 9.2 Hedging and pricing. 9.3 Hedging a risky derivative position. 9.4 Traditional hedging of bonds, loans and repos. 9.5 Risk-neutral or real parameters? 9.6 Components of CVA. 9.7 Recovery risk. 9.8 Static hedging. 9.9 Dynamic credit hedging. 9.10 Exposure. 9.11 Cross-dependency. 9.12 Aggregation of sensitivities. 9.13 Summary. Appendix 9.A Example of calculation of CVA Greeks. 10 Portfolio Models and Economic Capital. 10.1 Introduction. 10.2 Joint default. 10.3 Credit portfolio losses. 10.4 The impact of stochastic exposure. 10.5 Special cases of alpha. 10.6 Credit migration and mark-to-market. 10.7 Summary. Appendix 10.A Credit portfolio model. Appendix 10.B Simple treatment of wrong-way risk. 11 Counterparty Risk, Regulation and Basel II. 11.1 Introduction. 11.2 The birth of Basel II. 11.3 Basel II Framework for fixed exposures. 11.4 Exposure at default and Basel II. 11.5 Basel II internal model method. 11.6 Basel II and double-default. 11.7 Summary. Appendix 11.A Effective remaining maturity. Appendix 11.B The asset correlation and maturity adjustment formulas in the advanced IRB approach of Basel II. Appendix 11.C Netting and collateral treatment under the current exposure method (CEM) of Basel II. Appendix 11.D Definition of effective EPE. Appendix 11.E Double-default treatment of hedged exposures in Basel II. 12 Managing Counterparty Risk in a Financial Institution. 12.1 Introduction. 12.2 Counterparty risk in financial institutions. 12.3 Insurance company or trading desk? 12.4 How to calculate credit charges. 12.5 How to charge for counterparty risk. 12.6 Summary. 13 Counterparty Risk of Default-remote Entities. 13.1 The triple-A counterparty. 13.2 The value of monolines and CDPCs. 13.3 Summary. Appendix 13.A Simple model for a credit insurer. Appendix 13.B The valuation of credit insurer purchased protection. 14 The Role of a Central Counterparty. 14.1 Centralised clearing. 14.2 The viability of centralised clearing. 14.3 Conclusions. 15 The Future of Counterparty Risk. 15.1 A counterparty risk revolution? 15.2 Controlling credit exposure. 15.3 Collateral management. 15.4 The too-big-to-fail concept. 15.5 Credit value adjustment (CVA). 15.6 Hedging. 15.7 Credit derivatives. 15.8 Central counterparties. 15.9 The overall challenge. Glossary. References. Index.