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Account for counterparty credit risk (CCR) being treated as both credit risk and market risk, and outline what this implies for a financial institution's trading and risk management.

FRM® Part II · Credit Risk Measurement and Management · The Evolution of Stress Testing Counterparty Exposures · FRM2.CR.21.b

The idea

Counterparty credit risk sits on the border of two risk types. The size of the claim at default is the positive mark-to-market of the portfolio, which moves with interest rates, FX, equity, commodity and credit-spread factors, so it is market risk. Whether that claim is lost depends on the counterparty defaulting and on recovery, so it is credit risk. Expected loss is roughly the product of exposure, PD and LGD, and these terms may move together. The implications are as follows. The firm prices the risk through a credit valuation adjustment charged to trading desks, usually run by a CVA desk that hedges spreads with CDS and exposure with market instruments. It needs both credit limits and market risk limits. Wrong-way risk must be recognised. Basel III has both a default risk charge and a separate CVA charge. The usual error is treating CCR as credit risk alone with static exposure.

A practice question

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

Why is counterparty credit risk on OTC derivatives described as both credit risk and market risk?

  1. Defaults are driven by market prices while the exposure amount is fixed at the trade dateWhy not: Reverses the roles: the exposure is the market-driven variable and default is the credit event.
  2. It is measured with both VaR and credit ratings even though its cause is purely credit-relatedWhy not: Confuses the measurement tools with the risk drivers; the exposure really is market-driven.
  3. The amount at risk at default depends on market factors, while a loss occurs only if the counterparty defaults - correct
  4. The exposure is fixed like a loan and only the recovery rate depends on market pricesWhy not: Overlooks that the exposure itself changes with market factors; recovery is a secondary link.

Exposure = positive MTM, which moves with market factors (market risk); loss requires default and non-recovery (credit risk). Both enter loss = exposure x PD x LGD.

A harder one

Which is the most direct consequence of recognising CCR as both credit risk and market risk for a derivatives dealer?

  1. Counterparty risk is priced into trades through a CVA charged to trading desks, and hedged with both credit and market instruments - correct
  2. Counterparty risk is left to the credit department and excluded from trading desk P&L, because defaults are rare and the exposure is already covered by limitsWhy not: Treats CCR as pure credit risk, ignoring that its value moves daily with market factors.
  3. Limits are set on notional amounts only, since market moves do not affect the amount at riskWhy not: Ignores that exposure is the MTM-based amount and varies with market factors.
  4. Only the credit spread component of CVA is hedged, since exposure moves are not a source of lossWhy not: Hedges the credit side only and leaves the exposure's market risk unmanaged.

Because exposure is market-driven and default is credit-driven, CCR shows up as a mark-to-market CVA that must be priced, charged to desks, limited and hedged on both dimensions.

The hardest tier

How does the Basel III framework reflect that counterparty credit risk on OTC derivatives is both credit risk and market risk?

  1. A single default risk charge based on exposure at default, with spread-driven valuation losses left to general market risk capitalWhy not: Reflects Basel II, which captured default losses only; Basel III added a CVA charge for MTM losses.
  2. A CVA charge only, because mark-to-market losses were larger than default losses in the crisisWhy not: Drops the default risk charge; Basel III keeps both.
  3. A default risk charge based on exposure at default, plus a separate CVA capital charge for mark-to-market losses from counterparty spread changes - correct
  4. A market risk charge on the underlying derivative positions, with counterparty default losses assumed to be already in the MTMWhy not: Counterparty default losses are not in the risk-free MTM; they require their own charge.

Basel III keeps the default-risk (EAD-based) charge and adds a CVA risk charge because most crisis CCR losses were MTM losses from spread widening, not defaults.

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