ABSTRACT
Counterparty credit risk and collateral risk are other forms of credit risk, where the underlying credit risk is not directly generated by the economic objective of the financial transaction. Therefore, it can reduce the P&L of the portfolio and create a loss even if the business objective is reached. A typical example is the purchase transaction of a credit default swap. In this case, we have previously seen that the protection buyer is hedged against the credit risk if the reference entity defaults. This is partially true, because the protection buyer faces the risk that the protection seller also defaults. In this example, we see that the total P&L of the financial transaction is the direct P&L of the economic objective minus the potential loss due to the transaction settlement. Another example concerns the collateral risk, since the P&L of the financial transaction is directly affected by the mark-to-market of the collateral portfolio.
In this chapter, we study the counterparty credit risk (CCR) and show its computation. We also focus on the regulatory framework that has evolved considerably since the collapse of the LTCM hedge fund in 1997, which has shocked the entire financial system, not because of the investor losses, but because of the indirect losses generated by the counterparty credit risk 1 . The second section is dedicated to the credit valuation adjustment (CVA), which can be considered as the ‘little brother’ of the CCR. This risk has been mainly identified with the bankruptcy of Lehman Brothers, which has highlighted the market risk of CCR. Finally, Section three reviews different topics associated to the collateral risk management, particularly in the repo markets.
