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Counterparty Credit Risk: The new challenge for global financial markets
John Wiley and Sons Ltd, Dec 2009, Pages: 448
Counterparty risk is traditionally thought of as credit risk between derivatives counterparties. Since the credit crisis of 2007 onwards and the failures of large prestigious institutions such as Bear Sterns, Lehman Brothers, Fannie Mae and Freddie Mac, counterparty risk has been considered by most to be the key financial risk. Historically, many financial institutions limited their counterparty risk by only trading with the most sound counterparties. Market participants tended to underestimate its magnitude as a result of the implicit 'too big to fail' assumption and only a few large dealers invested heavily in assessed counterparty risk. This is set to change.
There are many solutions to the current counterparty risk problems, all of which mitigate the risk, however best mechanism for control is a full understanding of all aspects of counterparty credit risk, including the many possible risk mitigants. Only as more market participants become knowledgeable will the control of this new dimension of financial risk management will become practical. This book will be a complete guide to the area of counterparty credit risk. It will present a thorough description of this subject for readers familiar with basic financial markets. The implications and issues arising from the credit crisis will be a particular focus and specific relevant events (Lehman Brothers, Bear Stearns) will be discussed. The book will cover all important areas peripheral to counterparty credit risk such as collateral management, liquidity and credit derivatives. Mathematical aspects (pricing) will be covered but the aim is to keep these concepts as simple as possible and separate any complex formulas from the main text in appendices.
The first decade of the 21st Century has been disastrous for financial institutions, derivatives and risk management. Counterparty credit risk has become the key element of financial risk management, highlighted by the bankruptcy of the investment bank Lehman Brothers and failure of other high profile institutions such as Bear Sterns, AIG, Fannie Mae and Freddie Mac. The sudden realisation of extensive counterparty risks has severely compromised the health of global financial markets. Counterparty risk is now a key problem for all financial institutions.
This book explains the emergence of counterparty risk during the recent credit crisis. The quantification of firm-wide credit exposure for trading desks and businesses is discussed alongside risk mitigation methods such as netting and collateral management (margining). Banks and other financial institutions have been recently developing their capabilities for pricing counterparty risk and these elements are considered in detail via a characterisation of credit value adjustment (CVA). The implications of an institution valuing their own default via debt value adjustment (DVA) are also considered at length. Hedging aspects, together with the associated instruments such as credit defaults swaps (CDSs) and contingent CDS (CCDS) are described in full.
A key feature of the credit crisis has been the realisation of wrong-way risks illustrated by the failure of monoline insurance companies. Wrong-way counterparty risks are addressed in detail in relation to interest rate, foreign exchange, commodity and, in particular, credit derivative products. Portfolio counterparty risk is covered, together with the regulatory aspects as defined by the Basel II capital requirements. The management of counterparty risk within an institution is also discussed in detail. Finally, the design and benefits of central clearing, a recent development to attempt to control the rapid growth of counterparty risk, is considered.
This book is unique in being practically focused but also covering the more technical aspects. It is an invaluable complete reference guide for any market practitioner with any responsibility or interest within the area of counterparty credit risk
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