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On the White Board - October 2009
Oct 15, 2009
Counterparty Credit Exposure
The increase of default events/takeovers has raised concerns at many institutions, and the monitoring of risk concentrations at the counterparty level has become a high priority for most institutions.
Credit exposure is a measure used to quantify that risk. It represents the cost of replacing a transaction or a set of transactions with a counterparty if that counterparty defaults (today or at some time in the future) under the assumption of no recovery. One of the challenges in computing exposure is the way OTC markets are (dis)organized using bespoke or standardized agreements to define relationship terms (common legal framework) that include close out netting and collateral arrangements. Capturing these aspects is key.
Collateral arrangements do not eliminate counterparty risk, but allow for risk mitigation by setting thresholds, above which excess exposure is collateralized according to a frequency specified in the agreement.
The risk in the context of margining, is due to the mark-to-market fluctuations over the period of time between last successful collateral call/delivery and the close out of the transaction(s) in an event of default. As a mitigation tool, margining achieves two things:
a) Shorten the period of risk (defined as margin + close out) by reducing the margin period,
b) At each margin date, reduce the credit exposure to the level of the pre-established threshold using relevant collateral.
The exposure measure (at scenario level) can be expressed for a specific netting set
,
where PV(h) is the netting set value at h and C(h) is the available collateral. That collateral amount may be estimated using the collateral balance at time t’ (see figure) since that is the last successful collateral delivery date. Practically, this implies path dependent generation of Monte Carlo scenarios and potentially the modeling of both the collateral asset and the netting set dynamics over the period of risk.