Counterparty credit risk and credit value adjustment : a continuing challenge for global financial markets, second edition

481 Pages·2012·4.11 MB·English

by  Jon Gregory

BINDEX 08/14/2012 9:20:28 Page458
FFIRSXML 08/13/2012 11:42:57 Page1
Counterparty Credit Risk and
Credit Value Adjustment
Second Edition
FFIRSXML 08/13/2012 11:42:57 Page2
ToGinnie,GeorgeandChristy
FFIRSXML 08/13/2012 11:42:57 Page3
Counterparty Credit Risk and
Credit Value Adjustment
A Continuing Challenge for Global Financial Markets
Second Edition
Jon Gregory
AJohnWileyandSons,Ltd,Publication
FFIRSXML 08/13/2012 11:42:57 Page4
#2012JohnWiley&SonsLtd
Registeredoffice
JohnWiley&SonsLtd,TheAtrium,SouthernGate,Chichester,WestSussex,PO198SQ,UnitedKingdom
Fordetailsofourglobaleditorialoffices,forcustomerservicesandforinformationabouthowtoapplyforpermis-
sion to reuse the copyright material in this book please see our website at www.wiley.com.
Allrightsreserved.Nopartofthispublicationmaybereproduced,storedinaretrievalsystem,ortransmitted,inany
formorbyanymeans,electronic,mechanical,photocopying,recordingorotherwise,exceptaspermittedbytheUK
Copyright,DesignsandPatentsAct1988,withoutthepriorpermissionofthepublisher.
Wileypublishesinavarietyofprintandelectronicformatsandbyprint-on-demand.Somematerialincludedwith
standardprintversionsofthisbookmaynotbeincludedine-booksorinprint-on-demand.Ifthisbookrefersto
mediasuchasaCDorDVDthatisnotincludedintheversionyoupurchased,youmaydownloadthismaterialat
http://booksupport.wiley.com. For more information about Wiley products, visit www.wiley.com.
Designationsusedbycompaniestodistinguishtheirproductsareoftenclaimedastrademarks.Allbrandnamesand
productnamesusedinthisbookaretradenames,servicemarks,trademarksorregisteredtrademarksoftheirrespec-
tiveowners.Thepublisherisnotassociatedwithanyproductorvendormentionedinthisbook.Thispublicationis
designedtoprovideaccurateandauthoritativeinformationinregardtothesubjectmattercovered.Itissoldonthe
understandingthatthepublisherisnotengagedinrenderingprofessionalservices.Ifprofessionaladviceorother
expertassistanceisrequired,theservicesofacompetentprofessionalshouldbesought.
LibraryofCongressCataloging-in-PublicationData
Gregory,Jon,PhD
Counterpartycreditriskandcreditvalueadjustment:acontinuingchallengeforglobalfinancialmarkets/Jon
Gregory.–2nded.
p.cm.
Rev.ed.of:Counterpartycreditrisk.c2010.
Includesindex.
ISBN978-1-118-31667-2(cloth)–ISBN978-1-118-31665-8(ebk) –ISBN978-1-118-31664-1(ebk)
1. Derivativesecurities–Mathematicalmodels. 2. Riskmanagement. I. Gregory,Jon,Ph.D.
Counterpartycreditrisk. II. Title.
HG6024.A3G742012
0
332.6457—dc23
2012023249
AcataloguerecordforthisbookisavailablefromtheBritishLibrary.
ISBN978-1-118-31667-2(hardback) ISBN978-1-118-31665-8(ebk)
ISBN978-1-118-31666-5(ebk) ISBN978-1-118-31664-1(ebk)
Setin10/12ptTimesbyThomsonPress
PrintedinGreatBritainbyCPIGroup(UK)Ltd,Croydon,CR04YY
FTOCXML 08/14/2012 9:23:21 Page5
Contents
Acknowledgements xvii
ListofSpreadsheets xix
ListofAppendices xxi
SECTIONI INTRODUCTION 1
1 Introduction 3
2 Background 9
2.1 Introduction 9
2.2 Financialrisk 9
2.2.1 Marketrisk 9
2.2.2 Creditrisk 10
2.2.3 Liquidityrisk 10
2.2.4 Operationalrisk 10
2.2.5 Integrationofrisktypes 11
2.3 Value-at-Risk 11
2.3.1 Definition 11
2.3.2 ThedangersofVAR 12
2.3.3 Models 13
2.3.4 Correlationanddependency 14
2.4 Thederivativesmarket 14
2.4.1 Usesofderivatives 14
2.4.2 Exchange-tradedandOTCderivatives 15
2.4.3 Risksofderivatives 16
2.4.4 Toobigtofailandsystemicrisk 16
2.4.5 Creditderivatives 18
2.5 Counterpartyriskincontext 18
2.5.1 Theriseofcounterpartyrisk 18
FTOCXML 08/14/2012 9:23:21 Page6
vi Contents
2.5.2 CounterpartyriskandCVA 19
2.5.3 Mitigatingcounterpartyrisk 19
2.5.4 Counterpartyriskandcentralclearing 20
2.6 Summary 20
3 DefiningCounterpartyCreditRisk 21
3.1 Introducingcounterpartycreditrisk 21
3.1.1 Counterpartyriskversuslendingrisk 22
3.1.2 Settlementandpre-settlementrisk 22
3.1.3 Exchange-tradedderivatives 24
3.1.4 OTC-tradedderivatives 25
3.1.5 Reposandsecuritieslending 27
3.1.6 Mitigatingcounterpartyrisk 28
3.1.7 Counterpartyriskplayers 29
3.2 Componentsandterminology 30
3.2.1 Creditexposure 30
3.2.2 Defaultprobability,creditmigrationandcreditspreads 31
3.2.3 Recoveryandlossgivendefault 32
3.2.4 Mark-to-marketandreplacementcost 33
3.2.5 Mitigatingcounterpartyrisk 34
3.3 Controlandquantification 34
3.3.1 Creditlimits 35
3.3.2 Creditvalueadjustment 36
3.3.3 CVAorcreditlimits? 37
3.3.4 WhatdoesCVArepresent? 38
3.3.5 Hedgingcounterpartyrisk 38
3.3.6 Portfoliocounterpartyrisk 39
3.4 Summary 40
SECTIONII MITIGATIONOFCOUNTERPARTYCREDITRISK 41
4 Netting,Compression,ResetsandTerminationFeatures 45
4.1 Introduction 45
4.1.1 Theoriginsofcounterpartyrisk 45
4.1.2 TheISDAmasteragreement 45
4.2 Netting 46
4.2.1 Paymentnetting 46
4.2.2 Theneedforcloseoutnetting 47
4.2.3 Closeoutnetting 48
4.2.4 Nettingsetsandsubadditivity 49
4.2.5 Theimpactofnetting 50
4.2.6 Productcoverage 51
4.3 Terminationfeaturesandtradecompression 51
4.3.1 Resetagreements 51
4.3.2 Additionalterminationevents 52
FTOCXML 08/14/2012 9:23:21 Page7
Contents vii
4.3.3 Walkawayfeatures 55
4.3.4 Tradecompressionandmultilateralnetting 55
4.4 Conclusion 57
5 Collateral 59
5.1 Introduction 59
5.1.1 Rationaleforcollateral 59
5.1.2 Analogywithmortgages 60
5.1.3 Thebasicsofcollateralisation 61
5.1.4 Collateralusage 61
5.1.5 Thecreditsupportannex 62
5.1.6 Impactofcollateral 64
5.2 Collateralterms 64
5.2.1 Valuationagent 64
5.2.2 Typesofcollateral 65
5.2.3 Coverageofcollateralisation 66
5.2.4 Disputesandreconciliations 66
5.2.5 Margincallfrequency 67
5.2.6 Haircuts 68
5.2.7 Couponsandinterestpayments 69
5.2.8 Substitution,fundingcostsandrehypothecation 70
5.3 Definingtheamountofcollateral 71
5.3.1 TypesofCSA 71
5.3.2 Linkageofcollateralparameterstocreditquality 72
5.3.3 Threshold 72
5.3.4 Independentamount 73
5.3.5 Minimumtransferamountandrounding 73
5.4 Therisksofcollateralisation 74
5.4.1 Marketriskandthemarginperiodofrisk 74
5.4.2 Operationalrisk 75
5.4.3 Liquidityrisk 75
5.4.4 Fundingliquidityrisk 76
5.5 Summary 77
6 DefaultRemoteEntitiesandtheTooBigtoFailProblem 79
6.1 Introduction 79
6.1.1 Defaultremotenessandtoobigtofail 79
6.1.2 FromOTCtoexchange-traded 80
6.2 Specialpurposevehicles 82
6.3 Derivativeproductcompanies 82
6.3.1 StandardDPCs 82
6.3.2 ThedeclineofDPCs 83
6.4 MonolinesandcreditDPCs 84
6.4.1 Rationale 84
6.4.2 Monolineinsurers 84
FTOCXML 08/14/2012 9:23:21 Page8
viii Contents
6.4.3 Creditderivativeproductcompany 85
6.4.4 Themassivemonolinefailure 86
6.4.5 Whytheratingagenciesgotitwrong 90
6.4.6 A(verysimple)quantitativeanalysisofmonolines 91
6.5 Centralcounterparties 93
6.5.1 Introduction 93
6.5.2 Exchangesandclearing 94
6.5.3 Basicsofcentralclearing 94
7 CentralCounterparties 97
7.1 Centralisedclearing 97
7.1.1 Systemicrisk 97
7.1.2 Theimpactofthecrisis 98
7.1.3 CCPsinperspective 99
7.1.4 FunctionofaCCP 100
7.1.5 Multilateralnetting 101
7.1.6 HowmanyCCPs? 103
7.1.7 CoverageofCCPs 104
7.2 Logisticsofcentralclearing 105
7.2.1 Clearingmembers 105
7.2.2 Variationmargin 106
7.2.3 ImpactofdefaultofaCCPmember 106
7.2.4 Initialmargin 108
7.2.5 Reservefunds,capitalcallsandlossmutualisation 111
7.2.6 Interoperability 111
7.2.7 Non-clearingmembersandend-users 112
7.3 AnalysisoftheimpactandbenefitsofCCPs 113
7.3.1 Theadvantageofcentralisedclearing 114
7.3.2 HaveCCPsfailedbefore? 114
7.3.3 Theimpactofhomogenisation 115
7.3.4 WillaCCPbeallowedtofail? 116
7.3.5 CouldOTCderivativessurvivewithoutCCPs? 116
7.3.6 HurdlesandchallengesforthegrowthoftheCCPmarket 118
7.4 Conclusions 118
8 CreditExposure 121
8.1 Creditexposure 121
8.1.1 Definition 121
8.1.2 Bilateralexposure 122
8.1.3 Thecloseoutamount 123
8.1.4 Exposureasashortoptionposition 124
8.1.5 Futureexposure 124
8.1.6 Comparisontovalue-at-risk 125
8.2 Metricsforcreditexposure 126
8.2.1 Expectedfuturevalue 126