Counterparty Credit Risk and Credit Value Adjustment: A Continuing Challenge for Global Financial Markets

Overview

Failures of large financial institutions and sovereigns, leading to bankruptcies and dramatic bailouts have thrust counterparty credit risk heavily into the spotlight as the key element of financial risk management. The sudden realisation of extensive counterparty risks has severely compromised the balance sheets of banks globally, the health of global financial markets and state of the general economy. Understanding and managing counterparty risk and CVA (credit value ...

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Counterparty Credit Risk and Credit Value Adjustment: A Continuing Challenge for Global Financial Markets

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Overview

Failures of large financial institutions and sovereigns, leading to bankruptcies and dramatic bailouts have thrust counterparty credit risk heavily into the spotlight as the key element of financial risk management. The sudden realisation of extensive counterparty risks has severely compromised the balance sheets of banks globally, the health of global financial markets and state of the general economy. Understanding and managing counterparty risk and CVA (credit value adjustment) has become a key problem for all financial institutions.

Counterparty Credit Risk and Credit Value Adjustment: A Continuing Challenge for Global Financial Markets, Second Edition explains the history of the subject and its emergence as the key financial risk during the global financial crisis. The basics of counterparty risk management, including aspects such as potential future exposure, netting and collateral, are defined. Banks and other financial institutions have been developing their capabilities for pricing counterparty risk and these elements are considered in detail via a characterisation of credit value adjustment. Wrong-way counterparty risks are addressed in detail in relation to interest rate, foreign exchange, commodity and credit derivative products and regulatory capital for counterparty risk, including the recent Basel III requirements for CVA VAR is discussed. The implications of an institution valuing their own default via debt value adjustment (DVA) and funding costs (FVA) are also considered at length. The management of counterparty risk within an institution by a CVA desk is also discussed with the associated portfolio management and hedging of CVA described in full. Finally, the design and benefits of central clearing, a recent development to attempt to control the rapid growth of counterparty risk, is considered.

The first edition of this book has become a standard reference on the subject of counterparty credit risk. The second edition has been completely re-written to cover the recent extensive changes in theory, market practice and regulation and the new topics of risk-free valuation, funding considerations and Basel III capital requirements. The book is unique in being practically focused but also covers the more technical aspects. It is an invaluable complete reference guide for any market practitioner, policy maker, academic or student with any responsibility or interest within the area of counterparty credit risk and CVA.

The book has a supporting website, www.cvacentral.com, which contains spreadsheets, mathematical appendices and other supporting documentation, all of which are freely downloadable.

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Product Details

  • ISBN-13: 9781118316672
  • Publisher: Wiley, John & Sons, Incorporated
  • Publication date: 10/9/2012
  • Series: Wiley Finance Series
  • Edition number: 2
  • Pages: 480
  • Sales rank: 513,388
  • Product dimensions: 7.10 (w) x 9.90 (h) x 1.30 (d)

Meet the Author

Jon Gregory is an experienced practitioner in the area of financial risk management. From 1995 to 1997 he worked in the Fixed Income division of Salomon Brothers. From 1997 to 2005 he was with BNP Paribas and from 2005 until 2008 he was global head of credit analytics at Barclays Capital. Jon has published a number of papers and articles on risk management, credit derivatives and quantitative finance and is a regular speaker at international conferences. He was a co-author of the book Credit: A Complete Guide to Pricing, Hedging and Risk Management, nominated in 2001 for the Kulp-Wright award for the most significant text in risk management and insurance. He is currently a partner at Solum Financial based in London and advises a number of banks on their counterparty risk and CVA practices. He holds a PhD from Cambridge University.

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Table of Contents

SECTION I INTRODUCTION

1 Introduction

2 Background

2.1 Introduction

2.2 Financial risk

2.3 Value-at-risk

2.4 The derivatives market

2.5 Counterparty risk in context

2.6 Summary

3 Defining Counterparty Credit Risk

3.1 Introducing counterparty credit risk

3.2 Components and terminology

3.3 Control and quantification

3.4 Summary

SECTION II MITIGATION OF COUNTERPARTY CREDIT RISK

4 Netting, Compression, Resets and Termination Features

4.1 Introduction

4.2 Netting

4.3 Termination features and trade compression

4.4 Conclusion

5 Collateral

5.1 Introduction

5.2 Collateral terms

5.3 Defining the amount of collateral

5.4 The risks of collateralisation

5.5 Summary

6 Default Remote Entities and the Too Big to Fail Problem

6.1 Introduction

6.2 Special purpose vehicles

6.3 Derivative product companies

6.4 Monolines and credit DPCs

6.5 Central counterparties

7 Central Counterparties

7.1 Centralised clearing

7.2 Logistics of central clearing

7.3 Analysis of the impact and benefits of CCPs

7.4 Conclusions

8 Credit Exposure

8.1 Credit exposure

8.2 Metrics for credit exposure

8.3 Factors driving credit exposure

8.4 Understanding the impact of netting on exposure

8.5 Credit exposure and collateral

8.6 Risk-neutral or real-world?

8.7 Summary

SECTION III CREDIT VALUE ADJUSTMENT

9 Quantifying Credit Exposure

9.1 Introduction

9.2 Methods for quantifying credit exposure

9.3 Monte Carlo methodology

9.4 Models for credit exposure

9.5 Netting examples

9.6 Allocating exposure

9.7 Exposure and collateral

9.8 Summary

10 Default Probability, Credit Spreads and Credit Derivatives

10.1 Default probability and recovery rates

10.2 Credit default swaps

10.3 Curve mapping

10.4 Portfolio credit derivatives

10.5 Summary

11 Portfolio Counterparty Credit Risk

11.1 Introduction

11.2 Double default

11.3 Credit portfolio losses

11.4 Summary

12 Credit Value Adjustment

12.1 Definition of CVA

12.2 CVA and exposure

12.3 Impact of default probability and recovery

12.4 Pricing new trades using CVA

12.5 CVA with collateral

12.6 Summary

13 Debt Value Adjustment

13.1 DVA and counterparty risk

13.2 The DVA controversy

13.3 How to monetise DVA

13.4 Further DVA considerations

13.5 Summary

14 Funding and Valuation

14.1 Background

14.2 OIS discounting

14.3 Funding value adjustment

14.4 Optimisation of CVA, DVA and funding costs

14.5 Future trends

14.6 Summary

15 Wrong-Way Risk

15.1 Introduction

15.2 Overview of wrong-way risk

15.3 Portfolio wrong-way risk

15.4 Trade-level wrong-way risk

15.5 Wrong-way risk and credit derivatives

15.6 Summary

SECTION IV MANAGING COUNTERPARTY CREDIT RISK

16 Hedging Counterparty Risk

16.1 Background to CVA hedging

16.2 Component of CVA hedging

16.3 Exposure hedges

16.4 Credit hedges

16.5 Cross-dependency

16.6 The impact of DVA and collateral

16.7 Summary

17 Regulation and Capital Requirements

17.1 Introduction

17.2 Basel II

17.3 Exposure under Basel II

17.4 Basel III

17.5 Central counterparties

17.6 Summary

18 Managing CVA – The “CVA Desk”

18.1 Introduction

18.2 The role of a CVA desk

18.3 CVA charging

18.4 Technology

18.5 Practical hedging of CVA

18.6 Summary

19 The Future of Counterparty Risk

19.1 Key components

19.2 Key axes of development

19.3 The continuing challenge for global financial markets

References

Index

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