Counterparty Credit Risk

This book is a collection of analyses of methods and practices used to manage OTC derivative counterparty risk and their performance during the 2007-8 financial crisis. It covers the areas of counterparty risk measurement, pricing (CVA), hedging, collateralization, stress testing, back testing and integration into economic capital frameworks. Various new ideas, directions and models are discussed by a group of seasoned experts. The content of the book is even more relevant in light of the recent proposals of the Basel Committee of Banking Supervision for the changes in the regulatory capital on counterparty risks.

The Basel Committee for Banking Supervison (BCBS) has issued a substantive package of changes to the regulatory framework around counterparty credit risks in response to the events of the financial crisis of 2007-8. During this crisis, as in prior, counterparty credit risks have been at the center stage of the most crucial episodes.

Our book examines key aspects of counterparty risk management and models during the crisis and proposes practical guidance to improvements.

It contains a worth of insights useful to practitioners, regulators, consultants, accountants, lawmakers, auditors and researchers to understand the substantive, and often technical, issues on the table.

The book is a collection of clear and concise articles produced by some of the most experienced and prominent professionals in the field. All of them strived to produce material that is substantive and accessible. This provides an invaluable collection of ideas and tools to face the changes and challenges ahead and address some of the most important issues of the moment:

• The proposed changes in counterparty risk capital may cause regulatory capital on credit risk to double
• Banks will have to invest enormous resources to upgrade their counterparty risk management systems
• Methods and process will be enhanced to address the demands on the governance of wrong-way risks, model validation and backtesting, and stress testing
• CVAs and the market risk management of counterparty risks is key under the ruling of FAS 157 and IAS 39

The book consists of 14 chapters broken down into four broad areas:

· Chapters 1 to 5 cover topics related to counterparty risk measurement and management. It focuses on two very current subjects: systemic counterparty risk and collateralization.

· Chapters 6 to 10 cover topics related to the pricing and hedging of counterparty risks and of collateral arrangements. CVAs have caused massive losses to banks during the recent crisis and have motivated some of the recent the Basel Committee’s proposals for reforms of the regulatory capital on counterparty risks. The implications of collateral to OTC derivative valuation, funding costs and availability of funding are important current issues that are covered.

· Chapters 11 and 12 cover stress testing of counterparty risks. The recent experience made clear that stress tests frameworks need to be expanded and enhanced and some new and promising ideas are described.

· Chapters 13 and 14 cover back-testing of counterparty exposure models and the incorporation of counterparty risks into economic and regulatory capital frameworks.