Gregory counterparty credit risk; the new challenge for global financial markets (2010)

This page intentionally left blank Counterparty Credit Risk For other titles in the Wiley Finance series please see www.wiley.com/finance Counterparty Credit Risk The New Challenge for Global Financial Markets Jon Gregory A John Wiley and Sons, Ltd, Publication This edition first published in 2010 Copyright # 2010 John Wiley & Sons Ltd Registered office John Wiley & Sons Ltd, The Atrium, Southern Gate, Chichester, West Sussex, PO19 8SQ, United Kingdom For details of our global editorial offices, for customer services and for information about how to apply for permission to reuse the copyright material in this book please see our website at www.wiley.com The right of the author to be identified as the author of this work has been asserted in accordance with the Copyright, Designs and Patents Act 1988 All rights reserved No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, except as permitted by the UK Copyright, Designs and Patents Act 1988, without the prior permission of the publisher Wiley also publishes its books in a variety of electronic formats Some content that appears in print may not be available in electronic books Designations used by companies to distinguish their products are often claimed as trademarks All brand names and product names used in this book are trade names, service marks, trademarks or registered trademarks of their respective owners The publisher is not associated with any product or vendor mentioned in this book This publication is designed to provide accurate and authoritative information in regard to the subject matter covered It is sold on the understanding that the publisher is not engaged in rendering professional services If professional advice or other expert assistance is required, the services of a competent professional should be sought ISBN 978-0-470-68576-1 A catalogue record for this book is available from the British Library Project Management by OPS Ltd, Gt Yarmouth, Norfolk Typeset in 10/12pt Times Printed in Great Britain by CPI Antony Rowe Ltd, Chippenham, Wiltshire Contents Acknowledgements xvii List of Spreadsheets xviii List of Abbreviations xix Introduction xxi 1 1 2 3 4 6 7 8 9 10 10 11 Setting the Scene 1.1 Financial risk management 1.1.1 Market risk 1.1.2 Liquidity risk 1.1.3 Operational risk 1.1.4 Credit risk 1.1.5 Value-at-risk 1.1.6 Disadvantages of value-at-risk 1.2 The failure of models 1.2.1 Why models? 1.2.2 Good model, bad model 1.3 The derivatives market 1.3.1 What is a derivative? 1.3.2 Market structure 1.4 Risks of derivatives 1.4.1 Too big to fail 1.4.2 Systemic risk 1.4.3 Compensation culture 1.4.4 Credit derivatives 1.5 Counterparty risk in context 1.5.1 What is counterparty risk? 1.5.2 Mitigation of counterparty risk 1.5.3 Counterparty risk and integration of risk types 1.5.4 Counterparty risk and today’s derivatives market vi Contents Defining Counterparty Credit Risk 2.1 Introducing counterparty risk 2.1.1 Origins of counterparty risk 2.1.2 Repos 2.1.3 Exchange-traded derivatives 2.1.4 OTC derivatives 2.1.5 Counterparty risk 2.1.6 Counterparty risk versus lending risk 2.1.7 Mitigating counterparty risk 2.1.8 Counterparty risk players 2.2 Components and terminology 2.2.1 Credit exposure 2.2.2 Default probability and credit migration 2.2.3 Recovery 2.2.4 Mark-to-market 2.2.5 Replacement cost 2.2.6 Exposure 2.2.7 Exposure as a short option position 2.2.8 Potential future exposure (PFE) 2.3 Controlling counterparty credit risk 2.3.1 Trading with high-quality counterparties 2.3.2 Cross-product netting 2.3.3 Close-out 2.3.4 Collateralisation 2.3.5 Walkaway features 2.3.6 Monolines 2.3.7 Diversification of counterparty risk 2.3.8 Exchanges and centralised clearing houses 2.4 Quantifying counterparty risk 2.4.1 Credit lines 2.4.2 Pricing counterparty risk 2.4.3 Hedging counterparty risk 2.4.4 Capital requirements and counterparty risk 2.5 Metrics for credit exposure 2.5.1 Expected MtM 2.5.2 Expected exposure 2.5.3 Potential future exposure 2.5.4 EE and PFE for a normal distribution 2.5.5 Overview of exposure metrics 2.5.6 Expected positive exposure 2.5.7 Effective EPE 2.5.8 Maximum PFE 2.6 Summary Appendix 2.A Characterising exposure for a normal distribution 13 13 13 14 14 14 16 17 18 19 20 20 21 22 22 23 23 24 24 25 25 26 27 27 28 29 29 29 30 30 32 33 34 35 35 35 36 36 36 37 38 38 38 39 Contents Mitigating Counterparty Credit Risk 3.1 Introduction 3.1.1 Two-way or one-way agreements 3.1.2 Standardisation 3.2 Default-remote entities 3.2.1 High-quality counterparties 3.2.2 Special purpose vehicles 3.2.3 Central counterparties 3.3 Termination and walkaway features 3.3.1 Termination events 3.3.2 Additional termination events 3.3.3 Walkaway features 3.4 Netting and close-out 3.4.1 Close-out 3.4.2 Payment and close-out netting 3.4.3 The need for close-out netting 3.4.4 The birth of netting 3.4.5 Netting agreements 3.4.6 The ISDA Master Agreement 3.4.7 Product coverage 3.4.8 Netting and exposure 3.4.9 Advantages and disadvantages of netting 3.4.10 Multilateral netting 3.5 Netting and exposure 3.5.1 Negativity of MtM 3.5.2 Impact of correlation 3.5.3 Negative MtM of a netting set 3.5.4 Positive MtM of a netting set 3.6 Collateral 3.6.1 The basics of collateralisation 3.6.2 Analogy with mortgages 3.6.3 Setting up a collateral agreement 3.6.4 Valuation agent 3.6.5 Types of collateral 3.6.6 Coverage of collateralisation 3.6.7 Disputes and reconciliations 3.7 The mechanics of collateralisation 3.7.1 Linkage of collateral parameters to credit quality 3.7.2 Margin call frequency 3.7.3 Threshold 3.7.4 Independent amount 3.7.5 Minimum transfer amount 3.7.6 Rounding 3.7.7 Haircuts vii 41 41 41 42 42 42 42 43 44 44 45 45 46 47 48 48 50 50 50 51 51 51 53 54 54 55 57 58 59 60 61 61 62 63 63 64 65 65 66 66 67 68 68 68 viii Contents 3.7.8 Coupons and interest payments 3.7.9 Substitution, reuse of collateral and rehypothecation 3.7.10 Call-and-return example 3.8 Is risk mitigation always a good thing? 3.9 Summary Appendix 3.A EE of independent normal variables 70 71 71 73 74 74 Quantifying Counterparty Credit Exposure, I 4.1 Quantifying credit exposure 4.1.1 Mark-to-market ỵ add-ons 4.1.2 Semi-analytical methods 4.1.3 Monte Carlo simulation 4.1.4 Roll-off risk 4.2 Typical credit exposures 4.2.1 Loans, bonds and repos 4.2.2 Swaps 4.2.3 FX products 4.2.4 Options 4.2.5 Credit derivatives 4.2.6 Payment frequencies 4.2.7 Exercise dates 4.3 Models for credit exposure 4.3.1 Calibration 4.3.2 Risk-neutral or real? 4.3.3 Equities 4.3.4 FX 4.3.5 Commodities 4.3.6 Credit spreads 4.3.7 Interest rates 4.3.8 Advanced models 4.3.9 Model validation 4.3.10 Correlations 4.4 Netting 4.4.1 Modelling netting 4.4.2 Netting factor 4.4.3 Examples 4.5 Exposure contributions 4.5.1 Marginal EE 4.5.2 Simple two-trade marginal EE example 4.5.3 Marginal EE and correlation 4.5.4 General example 4.6 Summary Appendix 4.A Semi-analytical formula for exposure of a forward contract Appendix 4.B Computing marginal EE 77 77 78 79 80 82 84 84 84 85 85 86 89 89 90 91 91 93 94 94 94 95 96 97 97 98 98 99 99 101 102 102 103 104 104 105 106 396 Glossary Bermudan option An option where the buyer has the right to exercise at a set of discretely spaced times It is intermediate between a European option (which allows exercise only at expiry) and an American option (which allows exercise at any time) Bilateral netting (see also netting and multilateral netting) two parties A netting agreement between Black–Scholes formula A closed-form formula for valuing plain-vanilla options developed by Fischer Black and Myron Scholes in 1973 that led to the birth of pricing by replication for derivatives products Capital (see regulatory capital and economic capital) Capital asset pricing model (CAPM) A model that describes the relationship between risk and expected return in the pricing of risky securities The CAPM postulates that investors need to be compensated for the risk-free rate of interest and the additional investment risk they take The model states that an investor will require a return equal to the risk-free rate of interest plus a risk measure (beta) that depends on the correlation between the returns of the asset and those of the market Carry Net gain or expense on a position due to interest, dividends and other payments, normally expressed in annual terms (such as basis points per annum) Cashflow An individual fixed or floating payment made on a specific date, such as a bond coupon Centralised counterparty An entity that interposes itself as the buyer to every seller and as the seller to every buyer of a specified set of contracts Clean price The price of a bond without accrued interest Clearing To settle a trade by the seller delivering securities and the buyer delivering funds in the proper form A trade that does not clear is said to fail Clearing house A corporation, normally used in conjunction with an exchange, that facilitates the execution of trades by transferring funds, assigning deliveries and guaranteeing the performance of all obligations Collateral (or margin) agreement A contractual agreement under which one party must supply collateral to a second counterparty when an exposure of that second counterparty to the first counterparty exceeds a specified level Collateralisation The process of agreeing to and exchanging collateral or margin between two or more parties Collateralised debt obligation (CDO) A broad type of instrument that repackages individual (usually debt) securities into a product that can be sold on the secondary Glossary 397 market The underlying securities may be, for example, auto loans, credit card debt, corporate debt or even other types of CDOs Conduit An entity set up to assemble securities into a pool and issue other securities to investors that are ultimately guaranteed by the original pool of securities Contango The situation where futures prices exceed spot prices (the opposite of backwardation) Contango implies an upward-sloping forward curve often due to the underlying cost of storage Contingent CDS (see also CDS) A CDS contract that has a notional value linked to the value of another contract and therefore isolates counterparty credit risk arising from a reference derivative Convexity A financial instrument is said to be convex if the price increases (decreases) faster (slower) than corresponding changes in the price of the underlying Correlation Correlation measures linear dependence between variables A correlation coefficient provides a measure of the degree to which random variables are linked in a linear fashion A correlation coefficient will be positive when relative large or small values are associated together and vice versa Financial instruments that move together in the same direction to the same extent have highly positive correlations Instruments that move in the opposite direction to the same extent have highly negative correlations Credit default swap (CDS) A specific swap transaction involving the transfer of a third party’s credit risk from one party to another Credit event Trigger event in a credit default swap, determined at the outset of the transaction Markets standards include the existence of publicly available information confirming the occurrence, with respect to the reference credit, of bankruptcy, repudiation, restructuring, failure to pay, cross-default or cross-acceleration Credit exposure (see exposure) Credit-linked note (CLN) A funded credit derivative structure which is structured as a security with an embedded credit default swap allowing the issuer to transfer a specific credit risk to credit investors in note form A CLN is therefore a synthetic bond Credit migration A discrete change in the credit quality of an entity such that their credit-worthiness improves or worsens by a significant amount, often due to an up or downgrade in the underlying credit rating Credit rating A published ranking, based on financial analysis that is supposed to measure the ability of a corporate, entity or individual to meet future obligations The highest rating achievable is usually triple-A Credit spread A yield measure reflecting the cost of credit risk in a security 398 Glossary Credit Support Annex (CSA) A legal document regulating collateral for derivatives transactions A CSA defines the terms or rules under which collateral is posted or transferred between swap counterparties to mitigate exposure Terms defined include thresholds, minimum transfer amounts, eligible securities and currencies, haircuts and rules for the settlement of disputes Credit support amount The total net exposure that an institution has to their counterparty used in the context of a collateral agreement Any independent amounts specified by a collateral agreement would be included in the CSA Credit value adjustment (CVA) The difference between the risk-free and credit-risky values of a netting set where the risky value takes into account the possibility of the counterparty’s default CVA is the expected loss or value of counterparty credit risk By convention, a positive CVA represents a cost Cross-currency swap (or currency swap) A foreign exchange agreement between two parties to exchange principal and fixed rate interest payments in different currencies Unlike interest rate swaps, cross-currency swaps involve the exchange of the principal amount at maturity Debt restructuring A process that allows a company or a sovereign entity facing cashflow problems and in financial distress to renegotiate its debt payments (such as extending the maturity date) in order to improve or restore liquidity so that it can continue its operations and avoid often-impending bankruptcy Debt-to-equity swap A restructuring where a company reduces their leverage by exchanging debt for equity with the original debt cancelled Debt value adjustment (DVA) The opposite component to CVA which stems from a liability due to a negative exposure that would give rise to a gain if an institution were to default There is some debate over the relevance of institutions ‘‘pricing in’’ their own default probability when assessing counterparty risk Default probability the future Likelihood that an entity will default a some pre-defined interval in Dirty price (see also clean price) A quoted bond price, including accrued interest Distressed exchange An exchange of a security for another security or package of securities that amounts to a reduced financial obligation (such as a lower coupon or par amount) Duration The change in the value of a security resulting from a 1% change in interest rates and expressed in years Unlike maturity, duration takes into account interest payments that occur throughout the course of holding an instrument Duration therefore represents a weighted average of the cashflows from one or more securities Glossary 399 Economic capital The amount of actual risk capital that a firm requires to cover the risks that it takes, such as market risk, credit risk, operational risk and counterparty risk It is the amount of capital that is needed to secure survival in a worst case scenario Effective EE Same as EE but must be non-decreasing over a certain time period (typically year) Effective EPE Average of effective EE over time (see also EPE) Effective maturity A duration-based measure for a portfolio of derivatives reflecting the average lifetime of the transactions scaled by the exposure over time Exchange (or bourse) An organised market where standardised tradable securities, such as commodities, foreign exchange, futures and options contracts, are bought and sold by brokers and dealers who are members of the exchange Expected exposure (EE) Average or expected value of the exposure at some point in time Expected positive exposure (EPE) Average of the expected exposure (EE) over some pre-defined period (usually from the current time to the maximum maturity of the transactions in question) Expected shortfall An alternative to value-at-risk (VAR) which is more sensitive to the shape of the loss distribution in the ‘‘tail’’ or extreme, high-loss regions The expected shortfall gives the expected loss on a portfolio in the worst case scenario, defined by a quantile Expected shortfall is also called tail VAR Exposure (or credit exposure) Positive value of one or more transactions with a counterparty Should represent a net value where netting of transactions is possible Exposure at default (see exposure) Fannie Mae (Federal National Mortgage Association) ary mortgage market Flight to quality uncertainty The largest player in the second- The flow of funds from riskier to safer investments in times of market Freddie Mac (Federal Home Loan Mortgage Association) the secondary mortgage market The second largest player in Futures A standardised exchange-traded contract that requires delivery of a commodity, bond, currency or stock index, at a specified price, on a specified future date Futures are typically cash-settled and so allow an investor to go long or short an underlying for speculation or hedging purposes without ever having to deliver or take delivery of the underlying 400 Glossary Gamma Gamma (or convexity) is the degree of curvature in the financial contract’s price curve with respect to its underlying price It is the rate of change of the delta with respect to changes in the underlying price Gaussian distribution (see normal distribution) Haircut A deduction in the market value of a security held as collateral reflecting the price uncertainty of the underlying security Hazard rate An instantaneous default probability Hedge An instrument traded in order to reduce the risk of adverse price movements in another instrument or portfolio of instruments A hedging instrument therefore has price movements opposite to those of the underlying instruments It may consist of cash instruments or derivatives Historical volatility A measure of the actual volatility observed in the marketplace over a given time horizon in the past IMM dates The four dates of each year which most credit default swaps and option contracts use as their scheduled termination date The dates are the third Wednesday of March, June, September and December Implied volatility Volatility required to reproduce a traded price (normally an option) in relation to a certain model (usually the Black–Scholes formula) Often thought of as the market’s view of expected future volatility Independent amount Usually an upfront cash amount that is posted from one party to another and is independent of any other collateral or margin terms Also referred to as initial margin Initial margin (see independent amount) Interest rate cap A derivative in which the buyer effectively caps their exposure to rising interest rates by receiving payments at the end of each period if the interest rate exceeds an agreed strike price Interest rate floor A derivative in which the buyer effectively floors their exposure to rising interest rates by receiving payments at the end of each period if the interest rate falls below an agreed strike price Interest rate swap A contract requiring the exchange of interest payments on a specific notional amount Usually fixed payments are swapped against floating payments in a particular currency In the money The situation where an option has value if exercised immediately (although that may not be contractually possible) For a call (put) option, the current Glossary 401 underlying price must be above (below) the strike price In-the-money forward refers to the forward value of the underlying security and not the spot price Intrinsic value Difference between the exercise price of an option at any time and its market price at the same time It is therefore the value if the contract were to expire immediately as distinct from any potential value (time value for an option) Investment grade A bond considered ‘‘likely’’ to meet payment obligations Corresponds to ratings as good as or better than Baa and BBB for Moody’s and Standard & Poor’s, respectively ISDA (International Swaps and Derivatives Association) A trade organisation of participants in the market for OTC derivatives which publishes the Code of Standard Wording, Assumptions and Provisions for Swaps LIBOR (London Inter-Bank Offer Rate) This is the rate of interest at which banks offer to lend money to one another in the so-called wholesale money markets in London Liquidity risk The risk of not being able to trade within a reasonable tolerance in terms of the deviation from prevailing, expected or fair prices Loss given default (LGD) The amount of loss on a credit instrument after the borrower has defaulted It is typically stated as a percentage of the debt’s par value Margining (see collateralisation) Margin call frequency The contractual period between which an institution may request collateral (or margin) from a counterparty Can vary from a few days to continuous with daily margin calls being most common Margin threshold The largest amount of an exposure that remains outstanding until one party has the right to call for collateral Mark-to-market (MtM) The process of recording the price or value of a security, usually on a daily basis, to calculate profits and losses MtM is used to refer to the current value of one or more derivatives instruments Market risk The risk of losses due to daily fluctuations in the prices of securities such as equity, FX, interest rates and commodities Mean reversion The statistical tendency of an underlying financial variable to gravitate back towards some long-term average Minimum transfer amount The minimum amount that can be requested to be transferred as collateral (margin) 402 Glossary Monte Carlo simulation A technique for working out an integral (often in many dimensions) by generating uniformly distributed pseudo-random numbers and evaluating the underlying function at all of these points Multilateral netting (see also netting and bilateral netting) A netting agreement between three or more parties which is typically utilised by a central counterparty Netting set A set of transactions with a single counterparty that are subject to a legally enforceable bilateral netting arrangement Netting A legally enforceable arrangement covering two or more underlying contracts so that, in the event of the default or insolvency of one of the parties, positive (receivable) and negative (payable) MtM values of contracts can be netted against one another to arrive at a total liability or claim representing the value of all underlying contracts Normal (Gaussian) distribution The most common of statistical distributions, which typically results from a large sample of uncorrelated random events Over-the-counter (OTC) contract A privately negotiated derivatives contract that is transacted away from an exchange Options A contract giving the right but not the obligation to sell or buy a commodity, financial instrument or index, at a specified price for a certain period Out of the money The situation where an option has zero value if exercised immediately For a call (put) option, the current underlying price must be below (above) the strike price Out-of-the-money forward refers to the forward value of the underlying security and not the spot price Par or principal value The amount of an obligation upon which interest is calculated Pari passu Equal in all respects or enjoying the same rights without bias or preference If a derivatives exposure is said to be pari passu with a senior unsecured bond then it means that the same percentage amount can expect to be recovered on both contracts Path dependency A financial contract whose value depends on the path taken by the underlying market variable(s) P&L (profit and loss) A quantification of gains or losses on one or more financial contracts in a given period Put–call parity An arbitrage relationship that must exist between the prices of European put and call options that both have the same underlying, strike price and maturity date Glossary 403 Quantile Point on a distribution of values such that a given proportion of the values are less than or equal to the point For example, the 0.99 or 99% quantile represents a point where 99% of the values fall below (and correspondingly 1% fall above) Rating An evaluation of a corporate or municipal bond’s relative safety, according to the issuer’s ability to make required payments Bonds are rated by various rating agencies such as Standard & Poor’s and Moody’s Ratings range from triple-A (AAA or Aaa for Standard & Poor’s and Moody’s, respectively) to D, which represents a company in default Recovery rate The percentage amount that a creditor receives in relation to claims on a defaulted counterparty Regulatory capital The amount of Tier I and Tier II long-term funding that commercial banks are compelled to hold based upon the Basel Accord regulations for risk adjustment Remargin period Used to denote the time from when collateral (margin) is called for until it is actually received accounting for some worst case delays This will be equal to the margin call frequency with some additional conservative delay added Replacement cost The amount it would cost to replace an asset or derivative contract at current market rates Accounts for liquidity and transaction costs Risky annuity (see also annuity) An annuity taking into account the probability of default of the annuity payer with respect to each cashflow A risky annuity will be worth no more than the equivalent annuity SFT (structured finance transaction) A non-standard lending arrangement customised to the needs of a specific client which is more complicated than traditional loans, bonds and equity Complicated leveraged products such as CDOs fall under the definition of structured finance SIV (structured investment vehicle) A fund with the strategy to borrow money by issuing short-term securities at low interest and then lend that money by buying long-term securities at higher interest, making a profit for investors from the difference SIVs were a casualty of the credit crisis and ceased to exist by the end of 2008 SPE (special purpose entity, see SPV) SPV (special purpose vehicle) A legal entity (usually a limited company of some type or a limited partnership) created to fulfil narrow, specific or temporary objectives SPVs were often used by firms to isolate a transaction for the benefit of a client and so, in theory, they would not bear risk of default of that firm Standard deviation A measure used to characterise the variability of a random variable 404 Glossary Stress testing Simulating different financial market conditions and assessing their potential effects on a portfolio of financial instruments Strike price The price at which an option holder can buy or sell the underlying asset Also called exercise price Time value The amount by which the value of an option exceeds the intrinsic value It represents the potential gain from an increasing option premium in the future Total return swap (TRS) A financial contract which allows synthetic transfer of both the credit and market risk of an underlying asset Unexpected loss A term commonly used to give an indication of the volatility of losses around the expected loss The unexpected loss will be defined as a worst case loss at some confidence level The expected loss may or may not be subtracted from this value Value-at-risk (VAR) For a given confidence level and time horizon, VAR is defined as a value such that the probability that the loss on a portfolio exceeds this value in the defined time horizon is one minus the confidence level For example, a 99% VAR of $1m in 10 days means that the probability of having a loss of more than $1m in 10 days is 1% Variation margin Additional margin required to bring an account up to the required level due to market fluctuations Will normally correspond to the current exposure less any initial margin (independent amount) and previously posted margin but also accounting for minimum transfer amount and rounding Volatility Standard deviation represented on an annualised basis Walkaway feature (or extinguisher) Contractual feature that allows an institution to terminate (walk away from) a transaction in the event their counterparty defaults In case the MtM value to the institution is negative then this represents a gain from their counterparty defaulting Yield curve For a particular series of fixed income instruments such as government bonds, the graph of the yields to maturity of the series plotted by maturity References Altman, E (1968) ‘‘Financial ratios, discriminant analysis and the prediction of corporate bankruptcy,’’ Journal of Finance, 23, 589–609 Altman, E and V Kishore (1996) ‘‘Almost everything you wanted to know about recoveries on defaulted bonds,’’ Financial Analysts Journal, November/December Andersen, L., J Sidenius and S Basu (2003) ‘‘All your hedges in one basket,’’ Risk Magazine, November Arvanitis, A and J Gregory (2001) Credit: The Complete Guide to Pricing, Hedging and Risk Management, Risk Books Arvanitis, A., J Gregory and J-P Laurent (1999) ‘‘Building models for credit spreads,’’ Journal of Derivatives, 6(3), Spring, 27–43 Baird, D.G (2001) Elements of Bankruptcy, Third Edition, Foundation Press, New York Basurto, M.S and M Singh (2008) Counterparty Risk in the Over-the-Counter Derivatives Market, IMF Working Paper, November, pp 1–19 Available at SSRN: http://ssrn.com/ abstract=1316726 Bates, D and R Craine (1999) ‘‘Valuing the Futures Market Clearinghouse’s default exposure during the 1987 crash,’’ Journal of Money, Credit & Banking, 31(2) (May), 248–272 BCBS (2004) An Explanatory Note on the Basel II IRB Risk Weight Functions, Basel Committee on Banking Supervision, October Available at www.bis.org BCBS (2005) The Application of Basel II to Trading Activities and the Treatment of Double Default, Basel Committee on Banking Supervision Available at www.bis.org BCBS (2006) International Convergence of Capital Measurement and Capital Standards, A Revised Framework – Comprehensive Version, Basel Committee on Banking Supervision, June Available at www.bis.org Black, F and J Cox (1976) ‘‘Valuing corporate securities: Some effects of bond indenture provisions,’’ Journal of Finance, 31, 351–367 Black, F and M Scholes (1973) ‘‘The pricing of options and corporate liabilities,’’ Journal of Political Economy, 81(3), 637–654 Bliss, R.R and G.G Kaufman (2005) Derivatives and Systemic Risk: Netting, Collateral, and Closeout, FRB of Chicago Working Paper No 2005-03, May 10 Available at SSRN: http:// ssrn.com/abstract=730648 Bluhm, C., L Overbeck and C Wagner (2003) An Introduction to Credit Risk Modeling, Chapman & Hall Brady, N (1988) Report of the Presidential Task Force on Market Mechanisms, US Government Printing Office, Washington, DC Brigo, D and M Masetti (2005a) ‘‘Risk-neutral pricing of counterparty risk,’’ in M Pykhtin (Ed.), Counterparty Credit Risk Modelling, Risk Books Brigo, D and M Masetti (2005b) A Formula for Interest Rate Swaps Valuation under Counterparty Risk in Presence of Netting Agreements Available at www.damianobrigo.it Brigo, D., K Chourdakis and I Bakkar (2008) Counterparty Risk Valuation for EnergyCommodities Swaps: Impact of Volatilities and Correlation, June 24 Available at SSRN: http://ssrn.com/abstract=1150818 406 References Canabarro, E and D Duffie (2003) ‘‘Measuring and marking counterparty risk,’’ in L Tilman (Ed.), Asset/Liability Management for Financial Institutions, Institutional Investor Books Canabarro, E., E Picoult, and T Wilde (2003) ‘‘Analyzing counterparty risk,’’ Risk, 16(9), 117–122 Collin-Dufresne, P., R.S Goldstein and J.S Martin (2001) ‘‘The determinants of credit spread changes,’’ Journal of Finance, 56, 2177–2207 Cooper, I.A and A.S Mello (1991) ‘‘The default risk of swaps,’’ Journal of Finance, 46, 597–620 Das, S (2008) The Credit Default Swap (CDS) Market – Will It Unravel?, February Available at http://www.eurointelligence.com/Article3.1018+M583ca062a10.0.html Das, S and R Sundaram (1999) ‘‘Of smiles and smirks, a term structure perspective,’’ Journal of Financial and Quantitative Analysis, 34, 211–239 De Prisco, B and D Rosen (2005) ‘‘Modelling stochastic counterparty credit exposures for derivatives portfolios,’’ in M Pykhtin (Ed.), Counterparty Credit Risk Modelling, Risk Books Downing, C., S Underwood and Y Xing (2005) Is Liquidity Risk Priced in the Corporate Bond Market?, Working Paper, Rice University Duffie, D and M Huang (1996) ‘‘Swap rates and credit quality,’’ Journal of Finance, 51, 921–950 Duffie, D and K.J Singleton (2003) Credit Risk: Pricing, Measurement, and Management (Princeton Series in Finance), Princeton University Press Duffie, D and H Zhu (2009) ‘‘Swap rates and credit quality,’’ Journal of Finance, 51, 921–950 Duffee, G R (1996a) ‘‘Idiosyncratic variation of Treasury Bill yields,’’ Journal of Finance, 51, 527–551 Duffee, G R (1996b) ‘‘On measuring credit risks of derivative instruments,’’ Journal of Banking and Finance, 20(5), 805–833 Engelmann, B and R Rauhmeier (Eds.) (2006) The Basel II Risk Parameters: Estimation, Validation, and Stress Testing, Springer-Verlag Figlewski, S (1984) ‘‘Margins and market integrity: Margin setting for stock index futures and options,’’ Journal of Futures Markets, 13(4), 389–408 Financial Times (2008) ‘‘Banks face $10bn monolines charges,’’ June 10 Finger, C (1999) ‘‘Conditional approaches for CreditMetrics portfolio distributions,’’ CreditMetrics Monitor, April Finger, C., V Finkelstein, G Pan, J-P Lardy and J Tiemey (2002) CreditGrades Technical Document, RiskMetrics Group Fitzpatrick, K (2002) ‘‘Spotlight on counterparty risk,’’ International Financial Review, 99, November 30 Fleck, M and A Schmidt (2005) ‘‘Analysis of Basel II treatment of counterparty risk,’’ in M Pykhtin (Ed.), Counterparty Credit Risk Modelling, Risk Books, Geman, H (2005) Commodities and Commodity Derivatives, John Wiley & Co Geman, H and V.N Nguyen (2005) ‘‘Soy bean inventory and forward curve dynamics,’’ Management Science, 51(7), July, 1076–1091 Gemmill, G (1994) ‘‘Margins and the safety of clearing houses,’’ Journal of Banking and Finance, 18(5), 979–996 Ghosh, A., G Rennison, A Soulier, P Sharma and M Malinowska (2008) Counterparty Risk in Credit Markets, Barclays Capital Research Report Gibson, M.S (2005) ‘‘Measuring counterparty credit risk exposure to a margined counterparty,’’ in M Pykhtin (Ed.), Counterparty Credit Risk Modelling, Risk Books Glasserman, P and J Li (2005) ‘‘Importance sampling for portfolio credit risk,’’ Management Science, 51(11), November, 1643–1656 Glasserman, P and B Yu (2002) ‘‘Pricing American options by simulation: Regression now or regression later?’’, in H Niederreiter (Ed.), Monte Carlo and Quasi-Monte Carlo Methods, Springer-Verlag, Berlin References 407 Gordy, M (2002) Saddlepoint approximation of credit riskỵ, Journal of Banking and Finance, 26, 1335–1353 Gordy, M (2004) ‘‘Granularity adjustment in portfolio credit risk management, in G.P Szegoă (Ed.), Risk Measures for the 21st Century, John Wiley & Sons Gordy, M and B Howells (2006) ‘‘Procyclicality in Basel II: Can we treat the disease without killing the patient?’’ Journal of Financial Intermediation, 15, 395–417 Gordy, M and S Juneja (2008) Nested Simulation in Portfolio Risk Measurement, Working Paper Gregory, J (2008a) ‘‘A trick of the credit tail,’’ Risk, March, 88–92 Gregory, J (2008b) ‘‘A free lunch and the credit crunch,’’ Risk, August, 74–77 Gregory, J (2009) ‘‘Being two-faced over counterparty credit risk,’’ Risk, 22(2), 86–90 Gregory, J and J-P Laurent (2003) ‘‘I will survive,’’ Risk, June, 103–107 Gregory, J and J-P Laurent (2004) ‘‘In the core of correlation,’’ Risk, October, 87–91 Gupton, G.M., C.C Finger and M Bhatia (1997) CreditMetrics Technical Document, Morgan Guaranty Trust Company, New York Hamilton, D.T., G.M Gupton and A Berthault (2001) Default and Recovery Rates of Corporate Bond Issuers: 2000, Moody’s Investors Service, February Hardouvelis, G and D Kim (1995) ‘‘Margin requirements: Price fluctuations, and market participation in metal futures,’’ Journal of Money, Credit and Banking, 27(3), 659–671 Hartzmark, M (1986) ‘‘The effects of changing margin levels on futures market activity, the composition of traders in the market, and price performance,’’ Journal of Business, 59(2), S147–S180 Hille, C.T., J Ring and H Shimanmoto (2005) ‘‘Modelling counterparty credit exposure for credit default swaps,’’ in M Pykhtin (Ed.), Counterparty Credit Risk Modelling, Risk Books Hills, B., D Rule, S Parkinson and C Young (1999) ‘‘Central counterparty clearing houses and financial stability,’’ Bank of England Financial Stability Review, June, 122–133 Hughston, L.P and S.M Turnbull (2001) ‘‘Credit risk: Constructing the basic building block,’’ Economic Notes, 30(2), 257–279 Hull, J and A White (1990) ‘‘Pricing interest rate derivative securities,’’ Review of Financial Studies, 3(4), 573–592 Hull, J and A White (2004) Valuation of a CDO and an nth to Default CDS without Monte Carlo Simulation, Working Paper, September Hull, J., M Predescu and A White (2004) ‘‘The relationship between credit default swap spreads, bond yields, and credit rating announcements,’’ Journal of Banking and Finance, 28(11), November, 2789–2811 Hull, J., M Predescu and A White (2005) The Valuation of Correlation-dependent Credit Derivatives Using a Structural Model Available at SSRN: http://ssrn.com/abstract=686481 Jamshidian, F and Y Zhu (1997) ‘‘Scenario simulation: Theory and methodology,’’ Finance and Stochastics, 1, 43–67 Jarrow, R.A and S.M Turnbull (1992) ‘‘Drawing the analogy,’’ Risk, 5(10), 63–70 Jarrow, R.A and S.M Turnbull (1995) ‘‘Pricing options on financial securities subject to default risk,’’ Journal of Finance, 50, 53–86 Jarrow, R and S.M Turnbull (1997) ‘‘When swaps are dropped,’’ Risk, 10(5), 70–75 Jarrow, R.A and F Yu (2001) ‘‘Counterparty risk and the pricing of defaultable securities,’’ Journal of Finance, 56, 1765–1799 Johnson, H and R Stulz (1987) ‘‘The pricing of options with default risk,’’ Journal of Finance, 42, 267–280 Jorion, P (2007) Value-at-Risk: The new benchmark for managing financial risk, Third Edition, McGraw-Hill Kealhofer, S (1995) ‘‘Managing default risk in derivative portfolios,’’ in Derivative Credit Risk: Advances in Measurement and Management, Renaissance Risk Publications, London 408 References Kealhofer, S (2003) ‘‘Quantifying credit risk, I: Default prediction,’’ Financial Analysts Journal, January/February, 30–44 Kealhofer, S and M Kurbat (2002) The Default Prediction Power of the Merton Approach, Relative to Debt Ratings and Accounting Variables, KMV LLC, Mimeo KMV Corporation (1993) Portfolio Management of Default Risk, KMV Corporation, San Francisco Kolb, R.W and J.A Overdahl (2006) Understanding Futures Markets, Wiley/Blackwell Laurent, J-P and J Gregory (2005) ‘‘Basket default swaps, CDOs and factor copulas,’’ Journal of Risk, 7(4), 103–122 Leland, H (1994) ‘‘Corporate debt value, bond covenants, and optimal capital structure,’’ Journal of Finance, 49, 1213–1252 Levy, A and R Levin (1999) ‘‘Wrong-way exposure,’’ Risk, July Li, D.X (1998) ‘‘Constructing a credit curve,’’ in Credit Risk: A RISK Special Report, November, pp 40–44 Li, D.X (2000) ‘‘On default correlation: A copula function approach,’’ Journal of Fixed Income, 9(4), March, 43–54 Lomibao, D and S Zhu (2005) ‘‘A conditional valuation approach for path-dependent instruments,’’ in M Pykhtin (Ed.), Counterparty Credit Risk Modelling, Risk Books Longstaff, F.A and S.E Schwartz (2001) ‘‘Valuing American options by simulation: A simple least squares approach,’’ Review of Financial Studies, 14(1), 113–147 Matthews, R.A.J (1995) ‘‘Tumbling toast, Murphy’s law and the fundamental constants,’’ European Journal of Physics, 16, 172–176 Martin, R., K Thompson and C Browne (2001) ‘‘Taking to the saddle,’’ Risk, June, 91–94 Mashal, R and M Naldi (2005) ‘‘Pricing multiname default swaps with counterparty risk,’’ Journal of Fixed Income, 14(4), 3–16 MacKenzie, D (2006) An Engine, Not a Camera: How Financial Models Shape Markets, MIT Press Meese, R and K Rogoff (1983) ‘‘Empirical exchange rate models of the seventies,’’ Journal of International Economics, 14, 3–24 Merton, R.C (1974) ‘‘On the pricing of corporate debt: The risk structure of interest rates,’’ Journal of Finance, 29, 449–470 Moody’s Investors Service (2007) Corporate Default and Recovery Rates: 1920-2006, Moody’s Special Report, New York, February O’Kane, D (2007) Approximating Independent Loss Distributions with an Adjusted Binomial Distribution, EDHEC Working Paper O’Kane, D (2008) Pricing Single-name and Portfolio Credit Derivatives, Wiley Finance Ong, M.K (Ed.) (2006) The Basel Handbook: A Guide for Financial Practitioners, Second Edition, Risk Books Picoult, E (2002) ‘‘Quantifying the risks of trading,’’ in M.A.H Dempster (Ed.), Risk Management: Value at Risk and Beyond, Cambridge University Press Picoult, E (2005) ‘‘Calculating and hedging exposure, credit value adjustment and economic capital for counterparty credit risk,’’ in M Pykhtin (Ed.), Counterparty Credit Risk Modelling, Risk Books Pindyck, R (2001) ‘‘The dynamics of commodity spot and futures markets: A primer,’’ Energy Journal, 22(3), 1–29 Pirrong, C (2009) The Economics of Clearing in Derivatives Markets: Netting, Asymmetric Information, and the Sharing of Default Risks through a Central Counterparty Available at SSRN: http://ssrn.com/abstract=1340660 Polizu, C., F.L Neilson and N Khakee (2006) Criteria for Rating Global Credit Derivative Product Companies, Standard and Poor’s Working Paper References 409 Press, W.H., S.A Teukolsky, W.T Vetterling and B.P Flannery (2007) Numerical Recipes: The Art of Scientific Computing, Third Edition, Cambridge University Press Pugachevsky, D (2005) ‘‘Pricing counterparty risk in unfunded synthetic CDO tranches’’ in M Pykhtin (Ed.), Counterparty Credit Risk Modelling, Risk Books Pykhtin, M (2003) ‘‘Unexpected recovery risk,’’ Risk, 16(8), 74–78 Rebonato, R (1998) Interest Rate Options Models, Second Edition, John Wiley & Sons Reimers, M and M Zerbs (1999) ‘‘A multi-factor statistical model for interest rates,’’ Algo Research Quarterly, 2(3), 53–64 Remeza, A (2007) Credit Derivative Product Companies Poised to Open for Business, Moody’s Investor Services Special Report Rowe, D (1995) ‘‘Aggregating credit exposures: The primary risk source approach,’’ in Derivative Credit Risk, Risk Books, pp 13–21 Rowe, D and M Mulholland (1999) ‘‘Aggregating market-driven credit exposures: A multiple risk source approach,’’ in Derivative Credit Risk, Second Edition, Risk Books, pp 141–147 Sarno, L (2005) ‘‘Viewpoint: Towards a solution to the puzzles in exchange rate economics: Where we stand?’’ Canadian Journal of Economics, 38, 673–708 Sarno, L and M.P Taylor (2002) The Economics of Exchange Rates, Cambridge University Press Segoviano Basurto, M and M Singh (2008) Counterparty Risk in the Over-the-counter Derivatives Market, IMF Working Papers, pp 1–19 Available at SSRN: http://ssrn.com/abstract=1316726 Shadab, H.B (2009) ‘‘Guilty by association? Regulating credit default swaps,’’ Entrepreneurial Business Law Journal, August 19 Available at SSRN: http://ssrn.com/abstract=1368026 Shelton, D (2004) Back to Normal, Proxy Integration: A Fast Accurate Method for CDO and CDO-squared Pricing, Citigroup Structured Credit Research, August Singh, M and J Aitken (2009) Deleveraging after Lehman: Evidence from Reduced Rehypothecation, IMF Working Paper, March, pp 1–11 Available at SSRN: http://ssrn.com/ abstract=1366171 Sorensen, E.H and T.F Bollier (1994) ‘‘Pricing swap default risk,’’ Financial Analysts Journal, 50(3), May/June, 23–33 Soros, G (2009) ‘‘My three steps to financial reform,’’ Financial Times, June 17 Standard & Poor’s (2007) Ratings Performance 2006: Stability and Transition, S&P, New York, February 16 Standard & Poor’s (2008) Default, Transition, and Recovery: 2008 Annual Global Corporate Default Study and Rating Transitions, April Tavakoli, J.M (2008) Structured Finance and Collateralized Debt Obligations: New Developments in Cash and Synthetic Securitization, John Wiley & Sons Thompson, J.R (2009) Counterparty Risk in Financial Contracts: Should the Insured Worry about the Insurer? Available at SSRN: http://ssrn.com/abstract=1278084 Turnbull, S (2005) ‘‘The pricing implications of counterparty risk for non-linear credit products,’’ in M Pykhtin (Ed.), Counterparty Credit Risk Modelling, Risk Books Tzani, R and J J Chen (2006) Credit Derivative Product Companies, Moody’s Investor Services, March Vasicek, O (1997) The Loan Loss Distribution, KMV Corporation Wilde, T (2001) ISDA’s Response to the Basel Committee on Banking Supervision’s Consultation on the New Capital Accord, May, Annex Wilde, T (2005) ‘‘Analytic methods for portfolio counterparty risk,’’ in M Pykhtin (Ed.), Counterparty Credit Risk Modelling, Risk Books This page intentionally left blank ... blank Counterparty Credit Risk For other titles in the Wiley Finance series please see www.wiley.com/finance Counterparty Credit Risk The New Challenge for Global Financial Markets Jon Gregory. .. Introduction THE NEW CHALLENGE FOR GLOBAL FINANCIAL MARKETS In 2007 we started to experience what would be the worst financial crisis since the 1930s The crisis spread from origins in the United... in the credit markets, the counterparty risk problem became critical for the financial industry and resulted in a dramatic shrinkage of the market Chapter is an introduction to credit risk and credit