SPECIAL REPORT COUNTERPARTY CREDIT RISK

Spotlight on exposure

The pricing of derivatives credit charges and risk management of counterparty credit risk portfolios pose
many challenges. Julian Keenan reviews the approaches available and makes some recommendations

Counterparty credit

risk has become a major issue since the collapse of

Lehman Brothers last year, with regulators across
the globe urging banks to improve their risk management practices. In August 2008, for
instance, the Counterparty Risk Management Policy Group III published a report
recommending nancial institutions ensure their credit systems can compile detailed
market and credit risk exposures across all counterparties within hours.
Many banks have looked to manage counterparty exposures for some time, but there
has been little consensus on how best to hedge this risk. Most of the literature on the
subject has focused on the theoretical aspects of how to price the risk. However, there has
been little material on the practical aspects of running a counterparty risk desk. This
article seeks to summarise current practices within counterparty risk management,
highlight some of the main issues faced by counterparty risk managers, and oer a
solution to key pricing and hedging issues.
The risk control framework for counterparty credit risk is fairly standard across
derivatives dealers. The maximum potential exposure (MPE) is estimated for a given
counterparty derivatives portfolio, and new trades can only be added if this MPE does not
exceed a set credit limit. Generally, this framework serves as a useful control.
However, market participants employ a wide variety of methods to deal with the accounting
and hedging aspects of counterparty credit risk. Banks can, very broadly, be placed into three
dierent categories with respect to how counterparty exposure pricing and risk are treated:
n Trading approach: upfront counterparty credit pricing, based on the credit default swap
(CDS) market and market-implied volatility assumptions. The exposure is treated as
hybrid credit risk and is dynamically hedged.
n Portfolio manager approach: pricing can be market-implied as above, or based on
expected loss plus other pricing factors. Risk concentrations are removed to diversify the
portfolio, and research and credit analysis is used to identify the key risks to be mitigated.
n Traditional bank manager approach: pricing varies, from reserves based on historical
default probabilities to no counterparty credit risk pricing at all. Lines of credit are extended
to counterparties of acceptable credit quality, and risk is retained and held to maturity.
Trading approach

Julian Keenan, Commerzbank

1 Expected positive (EPE) and negative

exposure (ENE) for swap
EPE
ENE

Exposure (%)

2.5
2.0
1.5
1.0
0.5
0
0.5
1.0
1.5
2.0
2.5
3.0

48

2
3
Time (years)

Credit October 2009

Counterparty credit risk arises from the expectation that derivatives contracts can have a
positive or negative mark-to-market in the future, along with the possibility of either
partys default.
When a new counterparty trade is priced, a calculation of the credit component can be
made. Figure 1 shows the expected positive exposure (EPE) and expected negative
exposure (ENE) on an interest rate swap. The exposure prole is a function of the current
mark-to-market, the yield curve and interest rate volatility. The jagged prole is due to the
annual versus semiannual payment frequency. For simplicity, it is assumed there are no
other trades in the counterparty portfolio.
Ideally, the calculation will use a risk-neutral arbitrage-free pricing model (for example,
the Brace-Gatarek-Musiela model) to create multiple Monte Carlo scenario paths. Frontoce pricing models are revalued at each time step to produce the expected positive/
negative exposure proles.
If we ignore the possible dependence structure between the variables, the following pricing
components should be considered in calculating the net credit valuation adjustment (CVA):
CVA = (EPE counterparty CDS curve discount factor)
(ENE own risk CDS curve discount factor)
+ rebalancing transaction costs + cost of capital1
Readers may question why the banks own credit risk (OCR) can be applied to the
potential liability to discount the CVA. From a practical perspective, there are three main

COUNTERPARTY CREDIT RISK SPECIAL REPORT

arguments for this:

n In an ecient market, the buyer and
seller must both price in the possibility of
each others default to reach agreement on
price.2
n It produces fair value as per
International Accounting Standard 39
and Financial Accounting Standards
Board Statement 157.3
n If you dont include it, you will be
uncompetitive. The clearing price for
counterparty credit risk in the market
currently appears to include it.
On face value, the inclusion of OCR may
sound plausible. However, there may still be
some readers who want to see how this can
be hedged before they accept it as a valid
way to price. (For background information,
the reader is referred to Tang & Li, 2007).
Counterparty risk hedging challenges

A. There is no natural volatility hedge for

the EPE prole: in theory, we can hedge
with a default-probability-weighted
amount of an option on the underlying
derivative (strike at zero mark-to-market,
eective at a range of forward dates).
Obviously, this is not practical for most
products, especially where the underlying
is already an option. With complex
products, the counterparty credit risk
becomes a function of higher-order
volatility. In practice, vega risk is often
left unhedged or managed on a portfolio
basis with some proxy hedges. This leaves
signicant prot and loss (P&L) noise.
B. Cross-gamma due to volatile interest
rates and foreign exchange markets: the
problem here is that some portfolios are
highly forex- and interest rate-dependent.
In highly volatile markets, the credit
exposures deriving from the counterparty
portfolio gyrate around. For risky credits,
we may want to rebalance frequently to
keep the exposure hedge within a tight
tolerance. On a portfolio, we can take an
overall view of the forex/credit and
interest rate/credit cross-gamma. This is
now easier to manage, especially since
brokerage rm Icap started oering
contingent CDSs linked to the Markit
CDX.IG12 index and single currency and
cross-currency swaps. These are helpful in
hedging any correlated moves between
rates, foreign exchange and credit.
C. Wide bid/oer spreads in the CDS
market: many CVA desks have been hurt
by rebalancing transaction costs from
wide spreads and elevated volatility. As a
result, exposures need to be rebalanced
more frequently, right at the time when

spreads are at their widest. This means

CVA desks should incorporate a premium
for the potential to incur such costs.
D. The CDS market can be illiquid away
from the ve-year point: EPE proles are
a function of underlying trade maturity
and break dates. The prole may not
correspond to the liquid points on the
CDS curve. In practice, CVA desks will
run implied curve positions, as very
short-dated and very long-dated
exposures are hedged with three- to veyear or 10-year contracts. Again, these
features imply the CVA desk requires an
additional risk premium.
E. Estimating the chance of breaks,
terminations or restructuring: it has been
estimated that, for some counterparties, less
than 50% of all over-the-counter derivatives
traded will survive until maturity. This
might be caused by changed risk
management needs, which lead to
terminations or restructuring. This
possibility can reduce the duration of the
credit exposure, and hence the upfront
CVA. A desk that discounts for this
possibility will have a competitive edge over
one that does not. In addition, there are
relationship issues involved in exercising
mutual puts (breaks). Pricing the CVA to
the break date may be overly aggressive
since the break exercise may alienate the
customer. Meanwhile, the CVA may be
discounted at an early stage to attract
business or because future risk mitigation or
portfolio benets may be possible. Although
these issues are dicult to quantify, some
attempt is usually made due to the eect on
CVA pricing competitiveness.
F. Hedging of the banks own credit risk:
the model suggests you need to sell
protection on your own name to hedge
the CS01 and earn the required carry.
Obviously, selling CDS protection on
your own rm is a non-starter, so here are
some alternatives:
n Trade in and out of your own debt at
prevailing prices. However, treasury
departments are generally not keen on the
idea due to liquidity, accounting and
compliance reasons. The question is: is
selling a derivative with a potential
negative mark-to-market really of funding
benet to a bank?
n As a proxy hedge, sell the Markit
iTraxx Senior Financials index. However,
the basis risk can be signicant, especially
given the size that is required. If this
strategy was correct, the entire dealer
community would have to sell the index
in extremely large size. But to whom?

These trades would create bank-wide

systemic risk. The sizes involved preclude
selling the index and buying back on the
single-name constituents.
n Another proxy hedge involves selling
protection on a highly correlated credit
that is, your neighbouring national bank.
Again, the basis risk is unpalatable and
this also increases systemic risk.
n Many banks choose to ignore the OCR
issue. Potentially, there could be an
accounting rule change in the future. But
until then, there is the issue of how to
plug the negative carry/pricing gap. A
CVA desk would need to go very long
credit risk to do this. This has provided
many desks with a good reason to run
proprietary positions.
G. Hedging illiquid credit risk: many
people advocate a capital asset pricing
model approach to this. It is common for
risk managers and synthetic collateralised
debt obligation (CDO) dealers to think of
credit risk in terms of having a general
market component and an idiosyncratic
component. The general market component
can be hedged by a broad-based credit
index. The argument is that all corporate
credits, whether they have liquid CDSs or
not, are aected by common factors that
inuence default probability.
Therefore, can the purchase of CDS
index protection be regarded as an
acceptable hedge for illiquid credit risk?
It can certainly give the appearance of
eective hedging, particularly if the
illiquid credit is proxied to actively
traded CDS names or an index. By the
nature of the circular set-up, it will
appear to be hedged from a daily credit
spread P&L perspective.
One can also argue that credit spreads
show a high correlation to future default
probability. In that case, it might be
argued index protection could be acquired
and held to maturity, under the assumption the defaults will cancel each other out.
However, it is questionable, even over
the long run, that default rates on illiquid
small and medium-sized enterprises match
the index default rates. Also, default risk is
inherently idiosyncratic: it is a digital
outcome and does not occur with sucient
1

The capital charges for counterparty risk should be covered by the

CVA desk. Therefore, the cost of capital can be included in the
internal transfer price. In practice, as with transaction costs, this is
rarely included
2
Given that the corporate is usually the price taker, it may have a
weaker bargaining position in terms of trying to negotiate a discount
for bank risk
3
On June 18, the International Accounting Standards Board
requested feedback on the own credit risk issue (Credit Risk in
Liability Measurement). It is expected the accounting rules may
change in the future

risk-magazine.net

49

SPECIAL REPORT COUNTERPARTY CREDIT RISK

2 Cohort analysis: ratio of five-year CDS level to

long-run average five-year loss rates (19812008)
45

May 25, 2009

October 26, 2006

40
35
Ratio (x:1)

30
25
20
15
10
5
0
AA+ AA A+ A BBB BBB

BB+ BB

BB B+ B B B CCC

frequency in banks corporate customer

portfolios and in index composition to
ensure there is a good relationship.
The only completely eective hedge for
illiquid credit risk is to nd customers
willing to take the risk, either in note,
derivatives or securitised form. Demand is
currently very limited.
Portfolio management approach

The main feature of this approach is that

credit risk is retained (warehoused) and
is managed in the credit treasury or
credit portfolio management area.
Counterparty credit risk should be
combined with the banks loan portfolio
because there will be signicant overlap
of credit names. This will also ensure
optimal portfolio benets due to an
increase in the portfolio size.
This approach would generally permit
hedging of selected risks (where there is a
strong negative credit view), counterparty
risk swaps with other banks, and rebalancing of concentrations in the portfolio (for
optimisation purposes), while still
retaining a large long credit risk position.
The portfolio manager will seek to
obtain an optimal risk/return4 by
ensuring the portfolio is well diversied.
This involves taking out tall tree risks
(large absolute exposures) and reducing
risk factor concentrations (for example,
sector, country, and so on). A portfolio
model such as CreditMetrics, KMV or
CreditRisk+ could be used to help
optimisation. Further value could also be
added by taking well-researched views on
sectors and individual credits.
The pricing methodology shares some
similarities with the trading approach, in
that the expected positive exposures of
the derivatives should be calculated.
However, there is a greater degree of
exibility in terms of determining the
appropriate default probability curve

50

Credit October 2009

that is, we do not have to use the full

counterparty CDS curve.
The method advocated here involves
ignoring the own credit risk component
to pricing and stripping out some of the
components of the counterparty CDS
price that do not correspond to probability of default.
History has consistently shown that,
especially for investment-grade credits,
the expected loss represents only a small
fraction of the corporate bond or CDS
spread. However, historical data should be
used with care ratings typically refer to
through-the-cycle default probabilities
rather than point-in-time. A forwardlooking view is required. Therefore,
complete reliance on external ratings
should be avoided.
Market prices are the best mechanism for
establishing the consensus view and,
therefore, the most accurate estimates of
future events. CDS spreads incorporate the
latest views from the market. However,
these also contain the market risk premium.
In the portfolio pricing approach, the
market risk premium is stripped out and
the bank uses its own (risk-adjusted return
on capital (Raroc)) hurdle rate for the
return required. If the credit does not t
the portfolio, due to risk concentration or
outright default risk, it is expected to be
hedged. In this situation, the full counterparty CDS spread should be applied to the
EPE. If the counterparty credit risk is to be
warehoused in a diversied portfolio, then
to break even the following components
need to be considered:
n Expected loss.
n Information costs (the cost of doing
business).

n Premium to cover possibility of

needing to hedge fallen angel credit.
n Premium to cover possibility of
needing to hedge tall tree risk.
Whether the risk is hedged or warehoused, there will be an increased capital
utilisation from the new trade. This
capital will have a cost over the life of the
contract. The risk-adjusted return (net
P&L) of the new trade will need to exceed
the Raroc hurdle rate.
Portfolio management challenges

A. Diculty in estimating EPEs, as per

trading approach (E).
B. Estimation/calibration of expected
loss: as hinted above, there is no perfect
model for extracting this information from
the market. Judgement is required to netune the models to ensure the optimal
credit charges are being applied.
C. Optimisation of the portfolio:
signicant credit research is required to
avoid problem credits. There are few
portfolio managers who manage to
consistently generate alpha.
D. Accounting issues: fair-value
accounting, in the rst instance, seeks to
use observable pricing information.
However, secondary market CDSimplied default probabilities may not be
deemed relevant fair-value inputs into
the CVA model. This is because the
hold-to-maturity, bilaterally negotiated
OTC derivative counterparty risk is a
dierent market from the short-term
CDS secondary market.5
Therefore, the fair value of this risk can
be assessed with more traditional methods
of assessing default probability that is,
internal rating-implied default probabili-

3 Credit charging in the portfolio approach

New trade counterparty
credit quality/risk concentration?
- High default risk
- Risk concentration
Requires
liquid CDS

CDS input based

probability of default

- Safe credit
- Fits with portfolio

Fair value

Hedge book
(CDS, IRS, FX, etc)

Illiquid CDS
OR liquid CDS
is not an IAS 39
relevant input

Expected loss (EL) based

probability of default

Warehouse
Fallen angel/rising star liquid credits

Apply diversification
and alpha generation
(carry neutral)

CVA = EL + fallen angel premium

Credit income retained against
future expected losses and
hedging of fallen angel credits

Securitisation
market-based pricing

Structured solutions

Use structured solution to rebalance

portfolio of illiquid credits

COUNTERPARTY CREDIT RISK SPECIAL REPORT

Traditional bank manager approach

This approach relies on the existing risk

control framework of the bank. New risk
is added only if there are sucient credit
lines available. Thereafter, risk is
monitored in relation to limits and no
hedging is conducted.
A range of approaches to credit pricing
or reserving can be used:
n No explicit charging for risk.
n Reserve amount based on capital cost.
n Reserve amount based on current markto-market or mark-to-market plus add-on.
n Cost of line usage/standard risk cost.
Issues with traditional approach

A. Potential mis-pricing of counterparty

credit risk: if undercharged, the bank
may end up taking on derivatives
business for which it is not paid
sucient compensation for the expected
loss and associated costs. If overcharged,
then protable trades can be missed.
B. The banks credit portfolio can
become skewed to its customer base: this
can mean the portfolio is inecient
from a risk/return perspective.
C. The business is not incentivised to
reduce counterparty risk, either through
missed restructuring opportunities,
documentation clean-ups, inclusion or
exercise of breaks, etc.
Which is the best approach?

The magnitude of counterparty credit risk

at most second-tier dealers books will
equate to tens of billions of euros on a
loan-equivalent basis. This risk can be
spread across several thousand credit
names. This warrants signicant resources
being devoted to pricing and risk
management. Therefore, the traditional
approach is not recommended.
There are both advantages and disadvantages to the trading and portfolio management approaches. I believe the most important question to answer in relation to this
is: should banks hedge away their whole
credit portfolio and in so doing, pay away
the entire portfolio return?
Given that making correct credit
decisions is arguably most banks centre of
competence and source of revenue
4
Where the target could, for example, be dened as minimisation of
expected shortfall (average unexpected loss given some tail risk event
occurs) versus a return target
5
CDS spreads are generally inated compared with real default
probability due to technical factors, spread risk premiums and return
requirements

generation, hedging all credit risk seems a

bad idea. This is certainly so for the loan
book. For many institutions, this should
also apply to counterparty credit risk.
Commercial banks with large diversied portfolios of credit risk can add
further diversication by using the
portfolio approach. For institutions that
do not have such credit portfolios and
associated large credit research teams, the
trading approach may be more desirable.
This can also be advantageous if maximum risk minimisation is desired.
Summary of approaches

Trading approach: the bank targets a

at P&L. However, signicant premium
is paid out in hedge costs to the market
to reduce risk.
n Portfolio approach: the bank retains a
greater proportion of its counterparty
credit income. This portfolio benet
is passed on to the trading desks to
allow more business to be won. But
this approach can give rise to greater
P&L volatility.
n Traditional approach: potential for
mispricing of risk and signicant P&L
volatility. The credit risk portfolio is suboptimal from a risk/return perspective.
n

Conclusion

I have summarised the current practices

within counterparty risk management
and highlighted the main issues. I believe
the best solutions to these issues are:
1. Dont hedge the own credit risk
component. This implies it should not be
priced either.
2. Retain the vast majority of the income
from the banks credit portfolio, rather
than pay away hedging costs to the
market. However, the benets of
warehousing the risk in a portfolio and
retaining the credit income (along with
the potential improved competitiveness
in pricing) should be evaluated against
the risk appetite of the rm.
3. Use the portfolio management
approach to CVA pricing.
4. Hedge the risky credits (where there is
a strong negative view), especially where
credit risk does not t with the portfolio.
Where such dynamic hedging of
counterparty risk is required, the full
CDS spread (plus rebalancing costs)
should be used for pricing.
5. Focus the counterparty risk
management area on added-value
activities. These are:
n Calculation of accurate credit charges

4 Optimal risk/return achievable

12
10
8
Return

ties or a decomposition of CDS spreads to

extract only the probability of default.

Traditional
approach

Portfolio
management
approach

6
4
2

Trading
approach

0
0

20

40

60
Risk

80

100

120

to allow a bank to avoid adverse selection

of derivatives trades.
n Use CVA charging to create incentives
for the bank to reduce counterparty risk
by using collateral agreements, mutual
breaks and trade restructuring.
n Monetising net negative mark-tomarket counterparty positions for
example, creating netting trades or
holding seasoned bonds of the
counterparty to be used for set o, etc.
n Avoidance of risky trades and
counterparties for example, correlated
risks and fantasy trades (buying supersenior CDO protection from entities that
will not survive to pay out protection).
n Freeing credit lines to allow capacity to
trade.
...and in particular with the portfolio
approach...
n The ability to oer the sales department
a competitive price for the CVA that is,
a discount to implied CDS market riskneutral prices. Portfolio benets are
passed back in internal credit charging.
n Hedging tall trees and diversication
to improve the portfolio risk/return
characteristics. n
Julian Keenan set up the counterparty exposure
trading desk within the credit portfolio
management group at Commerzbank.
Email: julian.keenan@googlemail.comww

References
Brearley R and S Myers, 1996
Principles of corporate finance
McGraw-Hill

Rebonato R, 1996
Interest-rate option models
John Wiley & Sons

IASB
Credit risk in liability
measurement
Available at www.iasb.org

Tang Y and Li B, 2007

Quantitative analysis,
derivative modelling and
trading strategies in the
presence of counterparty risk
World Scientific Publishing

Pykhtin M, 2005
Counterparty credit risk
modelling
Risk Books

risk-magazine.net

51

Reproduced with permission of the copyright owner. Further reproduction prohibited without permission.