Counterparty credit risk and credit value adjustment : a continuing challenge for global financial markets, second edition

A practical guide to counterparty risk management and credit value adjustment from a leading credit practitioner Please note that this second edition of Counterparty Credit Risk and Credit Value Adjustment has now been superseded by an updated version entitled The XVA Challenge: Counterparty Credit Risk, Funding, Collateral and Capital. Since the collapse of Lehman Brothers and the resultant realization of extensive counterparty risk across the global financial markets, the subject of counterparty risk has become an unavoidable issue for every financial institution. This book explains the emergence of counterparty risk and how financial institutions are developing capabilities for valuing it. It also covers portfolio management and hedging of credit value adjustment, debit value adjustment, and wrong-way counterparty risks. In addition, the book addresses the design and benefits of central clearing, a recent development in attempts to control the rapid growth of counterparty risk. This uniquely practical resource serves as an invaluable guide for market practitioners, policy makers, academics, and students. Failures of large financial institutions and sovereigns, leading to bankruptcies and dramatic bailouts have thrust counterparty credit risk heavily into the spotlight as the key element of financial risk management. The sudden realisation of extensive counterparty risks has severely compromised the balance sheets of banks globally, the health of global financial markets and state of the general economy. Understanding and managing counterparty risk and CVA (credit value adjustment) has become a key problem for all financial institutions. Counterparty Credit Risk and Credit Value Adjustment: A Continuing Challenge for Global Financial Markets, Second Edition explains the history of the subject and its emergence as the key financial risk during the global financial crisis. The basics of counterparty risk management, including aspects such as potential future exposure, netting and collateral, are defined. Banks and other financial institutions have been developing their capabilities for pricing counterparty risk and these elements are considered in detail via a characterisation of credit value adjustment. Wrong-way counterparty risks are addressed in detail in relation to interest rate, foreign exchange, commodity and credit derivative products and regulatory capital for counterparty risk, including the recent Basel III requirements for CVA VAR is discussed. The implications of an institution valuing their own default via debt value adjustment (DVA) and funding costs (FVA) are also considered at length. The management of counterparty risk within an institution by a CVA desk is also discussed with the associated portfolio management and hedging of CVA described in full. Finally, the design and benefits of central clearing, a recent development to attempt to control the rapid growth of counterparty risk, is considered. The first edition of this book has become a standard reference on the subject of counterparty credit risk. The second edition has been completely re-written to cover the recent extensive changes in theory, market practice and regulation and the new topics of risk-free valuation, funding considerations and Basel III capital requirements. The book is unique in being practically focused but also covers the more technical aspects. It is an invaluable complete reference guide for any market practitioner, policy maker, academic or student with any responsibility or interest within the area of counterparty credit risk and CVA. The book has a supporting website, www.cvacentral.com, which contains spreadsheets, mathematical appendices and other supporting documentation, all of which are freely downloadable

A practical guide to counterparty risk management and credit value adjustment from a leading credit practitioner

Please note that this second edition of Counterparty Credit Risk and Credit Value Adjustment has now been superseded by an updated version entitled The XVA Challenge: Counterparty Credit Risk, Funding, Collateral and Capital.

Since the collapse of Lehman Brothers and the resultant realization of extensive counterparty risk across the global financial markets, the subject of counterparty risk has become an unavoidable issue for every financial institution. This book explains the emergence of counterparty risk and how financial institutions are developing capabilities for valuing it. It also covers portfolio management and hedging of credit value adjustment, debit value adjustment, and wrong-way counterparty risks. In addition, the book addresses the design and benefits of central clearing, a recent development in attempts to control the rapid growth of counterparty risk. This uniquely practical resource serves as an invaluable guide for market practitioners, policy makers, academics, and students.

306 15 Wrong-Way Risk 307 15.1 Introduction 307 15.2 Overview of wrong-way risk 307 15.3 Portfolio wrong-way risk 314 15.4 Trade-level wrong-way risk 319 15.5 Wrong-way risk and credit derivatives 331 15.6 Summary 337 SECTION IV MANAGING COUNTERPARTY CREDIT RISK 339 16 Hedging Counterparty Risk 341 16.1 Background to CVA hedging 342 16.2 Components of CVA hedging 346 16.3 Exposure hedges 349 16.4 Credit hedges 354 16.5 Cross-dependency 357 16.6 The impact of DVA and collateral 362 16.7 Summary 368 17 Regulation and Capital Requirements 371 17.1 Introduction 371 17.2 Basel II 372 17.3 Exposure under Basel II 375 17.4 Basel III 384 17.5 Central counterparties 399 17.6 Summary 401 18 Managing CVA -- The "CVA Desk" 403 18.1 Introduction 403 18.2 The role of a CVA desk 404 18.3 CVA charging 410 18.4 Technology 415 18.5 Practical hedging of CVA 419 18.6 Summary 425 19 The Future of Counterparty Risk 427 19.1 Key components 427 19.2 Key axes of development 430 19.3 The continuing challenge for global financial markets 432 References 435 Index 443