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Name and outline the various ways institutions can measure, manage and reduce counterparty risk.

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

The idea

Counterparty risk is measured with exposure metrics such as expected positive exposure and potential future exposure at a high percentile. It is managed with several tools. Close-out netting terminates all trades under one master agreement on default and replaces them by a single net amount, so gains offset losses. Collateral agreements transfer variation margin, often with a threshold and minimum transfer amount. This leaves residual exposure over the margin period of risk. Central clearing replaces bilateral exposures by exposure to a central counterparty, with margin and a default fund. Credit limits cap exposure. Buying credit default swap protection transfers default risk. Break clauses and downgrade triggers allow early termination. Diversification spreads exposure across names. Exam point: netting lowers exposure legally, collateral lowers it operationally, and both fail if the legal enforceability is doubtful.

Formulas

Collateral call under a threshold

Collateral call = E − K − C

E
the current exposure to the counterparty
K
the threshold left uncollateralised
C
the collateral already held, valued after haircuts

The minimum transfer amount only blocks a call smaller than itself. The threshold is never called, so it stays as unsecured exposure.

Exposure left over the margin period of risk

Residual exposure = z × σ × √MPR

z
the standard normal quantile for the confidence level, 2.326 at 99%
σ
the daily standard deviation of the portfolio's mark-to-market change, in currency
MPR
the margin period of risk in days

Variance grows with time, so the period's standard deviation is σ × √MPR. Daily margining does not remove this exposure.

A practice question

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

Which statement describes close-out netting?

  1. On default, each trade is settled separately, with gains collected and losses paid in full.Why not: Describes settlement without netting, which leaves the full gross exposure.
  2. Each day, parties transfer cash equal to the change in value of the portfolio.Why not: Describes variation margin (collateral), not close-out netting.
  3. On default, all trades under a master agreement are terminated and combined into a single net amount payable by one party to the other. - correct
  4. A third party takes over each trade and becomes the counterparty to both sides.Why not: Describes novation to a central counterparty, not netting under a bilateral agreement.

Close-out netting replaces many gross claims with one net claim, so a loss on one trade offsets a gain on another. It depends on legal enforceability.

A harder one

A bank has four derivatives with a counterparty under a legally enforceable master agreement with close-out netting. The mark-to-market values to the bank are +25, +10, -18 and -12 (USD million). The reduction in credit exposure due to netting is:

  1. USD 30 million - correct
  2. USD 5 millionWhy not: Reports the netted exposure itself rather than the reduction relative to gross exposure.
  3. USD 35 millionWhy not: Reports the gross exposure (25 + 10) rather than the reduction.
  4. USD 65 millionWhy not: Adds the absolute values of all four trades, treating negative values as gross exposure.

Gross exposure = 25 + 10 = 35. Net exposure = max(25 + 10 - 18 - 12, 0) = 5. The reduction is 35 - 5 = 30.

The hardest tier

A bank's collateralised portfolio has no threshold and daily variation margin, but if the counterparty defaults the margin period of risk is 10 business days. The daily standard deviation of the portfolio value is USD 2 million, and changes are assumed normal with zero mean and independent across days. The 99% one-sided exposure to loss over the margin period of risk (z = 2.326) is closest to:

  1. USD 4.7 millionWhy not: Uses a one-day horizon instead of the 10-day margin period of risk.
  2. USD 46.5 millionWhy not: Scales volatility linearly with 10 days rather than by the square root of time.
  3. USD 14.7 million - correct
  4. USD 10.4 millionWhy not: Uses the 95% quantile (1.645) rather than the 99% quantile that the question specifies.

Variance scales with time, so the 10-day standard deviation is 2 x sqrt(10) = 6.32. Exposure = 2.326 x 6.32 = 14.7. Even with daily margin, the bank bears 10 days of market moves.

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