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Describe what counterparty risk is and distinguish it from the risk in lending.

FRM® Part II · Credit Risk Measurement and Management · Counterparty Risk and Beyond · FRM2.CR.15.a

The idea

Counterparty risk is the risk that the other side of a transaction defaults before the final cash flows are settled, so that you lose value you were still owed. Lending is the simple case. Only the lender is exposed, the exposure is the known amount advanced, and the loss is that amount × the loss given default. A derivative differs in three ways. The exposure is uncertain, because the contract value moves with market prices. It can be positive or negative, so either party may turn out to be the creditor, and the risk is two-sided. Only a positive value is at risk. A negative value is still owed in full to the defaulted estate. Because exposure is driven by markets and default by credit quality, counterparty risk blends market and credit risk. Here V is the contract value at the default date. Exam point: the exposure at default is the larger of V and zero, never the notional. Exposure = max(V, 0).

Formulas

Credit exposure on a derivative

Exposure = max(V, 0)

V
the mark-to-market value of the contract or netting set to you at the default date

A negative value is still owed in full to the defaulted estate, so it is not exposure. Averaging V across scenarios before flooring at zero understates expected exposure.

A practice question

From the question bank, with the reason each wrong option is wrong.

Which statement best describes counterparty risk on a derivative contract?

  1. The risk that the counterparty defaults before the final settlement of the contract's cash flows, causing a loss if the contract then has positive value to the holder. - correct
  2. The risk that the derivative loses value because the underlying price or rate moves against the holder.Why not: Describes market risk; counterparty risk is about the other side failing to perform, not about price moves.
  3. The risk that the holder cannot raise enough cash or liquid collateral to meet margin calls on the contract when markets are stressed, so that it is forced to close out positions and sell other assets at a loss.Why not: Describes liquidity (funding) risk, not the risk of the counterparty defaulting.
  4. The risk that the dealer prices the contract wrongly at inception because of an error in its valuation model.Why not: Describes model risk; it has no connection to the counterparty failing to pay.

Counterparty risk is a default risk on a transaction that is still unsettled: the loss arises only if the counterparty defaults while the contract is worth something to you. The other options describe market, liquidity and model risk.

A harder one

A risk manager says that counterparty risk on a derivative is a hybrid of market risk and credit risk. Which statement best supports this view?

  1. The loss depends only on the default probability, because once collateral is posted the market variables cancel out and the contract's value no longer affects the amount lost at default.Why not: Collateral reduces but never removes the dependence on market moves, and without collateral exposure is fully market driven.
  2. The loss depends only on the notional and the credit rating, because the market value is irrelevant at default.Why not: Treats notional as the exposure; the claim at default is the market value, not the notional.
  3. The size of the loss depends on the contract's value at the default date, which is driven by market variables, and on whether the counterparty defaults, which is driven by credit quality. - correct
  4. The loss depends on market variables only, because default of a counterparty is assumed to be independent of price moves.Why not: Ignores that credit quality determines whether default happens; independence is an assumption, not a reason to drop the credit component.

The exposure at default comes from the market value of the contract (market risk), while the chance and severity of default come from credit risk. Both are needed, and any dependence between them is wrong-way or right-way risk.

The hardest tier

A bank has an uncollateralised swap with a counterparty. At the future date when default could occur, the swap's mark-to-market to the bank is USD 14 million with probability 30%, USD 2 million with probability 30% and -USD 6 million with probability 40%. Assuming the counterparty defaults at that date and loss given default is 60%, the expected loss on the swap at that date is closest to:

  1. USD 2.88 million - correct
  2. USD 1.44 millionWhy not: Uses the expected MtM of 2.4 instead of the expected positive exposure of 4.8; ignores that negative values are floored at zero.
  3. USD 4.32 millionWhy not: Uses the expected absolute MtM of 7.2, counting the negative scenario as an exposure.
  4. USD 1.92 millionWhy not: Multiplies expected positive exposure by the recovery rate (40%) instead of the loss given default (60%).

Expected positive exposure = 0.3 x 14 + 0.3 x 2 + 0.4 x 0 = 4.8. Expected loss = 4.8 x 60% = 2.88. Negative MtM is not credit exposure, so the mean value of 2.4 understates it.

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