Counterparty Credit Risk

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Counterparty Credit Risk

Measuring & Assigning Counterparty Credit Risk Lines

In simple terms, counterparty credit risk is the risk of a customer (the counterparty) defaulting on a payment. There are levels of default, some easier to cure than others. A technical default is more easily cured than a straight “failure to pay” simply because the counterparty can prove receipt of said funds in a short time period. The delay in payment could be the result of human error, a failure to receive funds from their counterparty, etc. A “failure to pay” is a straight default where the counterparty can provide no assurance as to when they will be able to pay.

Counterparty Risk of Uncleared Derivatives

For uncleared swaps, counterparties will operate as they’ve done since the 1980s. The counterparties had a risk to each other — with the counterparty “in-the-money” having the risk that his counterparty is unable to meet their obligations. The mitigation of this risk will be managed in a similar manner, using similar documentation.  PRODUCTS > Derivatives > Futures

Counterparty Risk of Cleared Derivatives

The counterparty risk of cleared derivatives more fully mitigates counterparty credit risk, especially from the client’s point of view. For the individual clearing swaps, they are insulated against the contagion of other clearing clients defaulting. For the clearinghouse as long as they’re fully operational, have a robust Risk Management Committee and meet with other CCP’s regularly they are able to provide this risk mitigation. But because of the number of moving parts (many dealers and many clients), the probability associated with default is larger.  PRODUCTS > Derivatives > Futures [/vc_column_text][/vc_tab]

Credit Risk

Measuring and Managing the Credit Risk of a Bond Portfolio

Credit risk is different from counterparty credit risk. Credit Risk relates to the default of assets in your portfolio.

  • Non-payment of interest on a note or loan
  • Non-payment of the principal of a note or loan

When assigning a Credit Risk limit to a bond portfolio many risks are taken into account. Each risk is measured separately and as a portfolio of the same risk in other bonds.

  • Liquidity risk: is the asset liquid enough to trade; as bonds age, they become less liquid, the bid-ask spread gets wider. It will cost more to reverse your positions.
    • Measured as bid-ask spread / 2
    • The % of the outstanding bonds that are freely trading in the open market.
  • Concentration risk: risk your client has too much risk in one market sector
  • Collateral risk: especially under agreements which allow for re-hypothecation (to be lent), are carefully measured and care is taken not to post collateral of great value (the on-the-run note, the most liquid note in a class, etc. )
  • Call/Put risk: A callable bond will be called if interest rates go down or the credit risk of the corporation has improved significantly. The right to call the bond from the bondholders has a value or premium. While we can use some of the same variables to price the bonds embedded call.
    • Typically a call is exercised if it’s “in-the-money”, the price of the bond is above the strike price.
    • In a corporate call, the corporation may not save enough money to call the bond making this variable very difficult to value
  • The Call feature’s value is often financed by the Put Feature
  • The Put feature allows a bondholder to “put” the bond back to the issuer and request their principal money back.
  • The Put feature is typically used to finance the cost of the call. So you will often see both features used together.
  • The Call feature requires the owner to replace the bond in their portfolio.

The Outline of Operational Risk

Operations Risk & the Derivatives Value Chain

Operational Risk speaks to any risk along the value chain. They are the errors which typically combine human error and misunderstanding.

Areas of Operational Risk

The areas known as “operational” are any risk which can be ascribed to events which placed the institution at risk of fine(s) or censure.

Errors Found During Regulatory Examinations

Banks, Broker-Dealers, Insurance Companies, and other financial services related entities are examined by their Regulatory Oversight Organizations. Regulatory Examinations are vital to an organization. Personnel is given strict orders not to answer any questions and is given the name and contact information to whom they should refer the questioner. Eye contact was limited and the examiners were given their own space from which to work. The examiners were not allowed in the trading rooms or on floors where senior management would greet and meet with clients.

Errors resulting from Lack of Follow-Up

If certain notices to “cure” are given by regulators, the letter includes a period during which they were required to cure the issue. For example, if credit work had been delayed and was listed by regulators to review the entity and provide the updated report to the examining regulator. The cure list could include anything from credit reports to the number of time stamps on an execution ticket.

Errors Resulting From Human Error

Other types of risk are pure human error. For example:

  • Improper Affirmation of a contract
  • Non-Receipt of a signed confirmation
  • Error in static data
  • Error in cash accrual
  • Error in Documentation

Ways to Correct Operational Risk

Integrated Training, as taught by MHDS is an online or blended program given to the entire value chain. We pay particular attention to those job functions that worked directly before or after a specific function. For example, each middle office job function role play so that affirmation understands the process of submitting the trade (pre-affirmation) and ensuring receipt of a signed confirmation (post-confirmation). This allows all three functions to introduce redundancies and work like a well-oiled team.

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