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Name the institutions that carry substantial counterparty risk and outline their position.

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

The idea

Counterparty risk is concentrated in institutions that sit on many derivative trades or sell credit protection. Dealer banks face it on a huge scale and hedge with each other. Monoline insurers sold large amounts of credit protection on structured credit without posting collateral, relying on a high rating. Their buyers therefore held large claims that moved the wrong way relative to the monolines' own survival. Insurers and hedge funds can face collateral calls when markets move or ratings fall. Sovereigns, supranationals and many corporates often do not post collateral, which leaves dealers with uncollateralised exposure. A central counterparty stands between buyers and sellers. It concentrates risk, and it relies on margin, a default fund and its own capital. Exam point: the biggest concerns are one-sided collateral, wrong-way risk and concentration, not mere trading volume.

A practice question

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

Which institutions are the main intermediaries in the OTC derivatives market and so carry the largest bilateral counterparty exposures?

  1. Retail depositors, who hold large uncollateralised derivative books against their banks.Why not: Retail depositors do not trade OTC derivatives with banks in size.
  2. Large dealer banks, which sit on one side of most OTC trades and hedge with each other. - correct
  3. Non-financial corporates, who typically trade the largest notional amounts to market-make.Why not: Corporates use derivatives to hedge their own needs and do not make markets.
  4. Stock exchanges, which guarantee every OTC trade directly.Why not: Exchanges list and match trades; they do not guarantee OTC trades.

Dealers are the hubs of the OTC market: they face end-users on one side and other dealers on the other, so their combined exposures are large.

A harder one

Which statement best describes the position of a central counterparty (CCP) in a cleared market?

  1. It removes counterparty risk entirely, because a CCP can never fail and so its members need not post margin or contribute to any default fund at all.Why not: A CCP can fail; it concentrates risk and relies on resources that can be exhausted.
  2. It takes proprietary positions in the market and earns the bid-offer spread from members.Why not: A CCP runs a matched book and does not take market positions for profit.
  3. It becomes buyer to every seller and seller to every buyer, concentrating counterparty risk in one entity that is protected by margin, a default fund and its own capital. - correct
  4. It guarantees only the first leg of each trade, leaving members to manage the remaining exposure bilaterally.Why not: A CCP stands behind the whole trade through novation, not just the first leg.

Through novation, the CCP replaces bilateral exposures with exposure to itself. This reduces the number of links but concentrates risk, which is why margin and default funds matter.

The hardest tier

A dealer buys credit protection on a reference portfolio from a protection seller with no collateral agreement. In a normal state (probability 90%) the protection is worth nothing and the seller's one-year default probability is 2%. In a stress state (probability 10%) the protection is worth USD 60 million and the seller's default probability is 15%. With loss given default of 50%, the expected loss allowing for this dependence is closest to:

  1. USD 0.10 millionWhy not: Assumes independence of exposure and default: average PD of 3.3% x average exposure of 6 x 50%.
  2. USD 0.45 million - correct
  3. USD 0.99 millionWhy not: Applies the average PD of 3.3% to the stress-state exposure of 60, ignoring that stress occurs only 10% of the time.
  4. USD 0.06 millionWhy not: Combines the normal-state default probability of 2% with the average exposure of 6, missing that defaults cluster in stress.

Expected loss = 10% x 15% x 60 x 50% = 0.45; the normal state contributes zero exposure. Independence would give about 0.10, so wrong-way risk raises the loss more than fourfold.

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