counterparty-risk

What this skill does

# Counterparty Risk

## Purpose
Guide the measurement and management of counterparty credit risk in securities trading and OTC transactions. Covers counterparty exposure calculation, credit risk assessment, netting and close-out arrangements, collateral management, ISDA master agreement structures, central clearing mandates, and counterparty risk monitoring. Enables building or evaluating systems and processes that manage the risk that a trading counterparty fails to meet its obligations.

## Layer
11 — Trading Operations (Order Lifecycle & Execution)

## Direction
both

## When to Use
- Measuring current and potential future exposure to a trading counterparty
- Setting or reviewing counterparty credit limits for an institutional trading desk
- Evaluating netting benefits under ISDA Master Agreements or through central clearing
- Designing or auditing collateral management processes for bilateral OTC trades
- Structuring or reviewing Credit Support Annex (CSA) terms for margin exchange
- Assessing whether a derivative product must be centrally cleared under Dodd-Frank or EMIR
- Monitoring counterparty creditworthiness using ratings, CDS spreads, and financial analysis
- Managing settlement risk and Herstatt risk in FX and cross-border transactions
- Responding to a counterparty credit deterioration event (rating downgrade, CDS widening)
- Quantifying wrong-way risk where exposure and counterparty credit quality are correlated
- Building dashboards for real-time counterparty exposure monitoring and limit utilization

## Core Concepts

### Counterparty Exposure Measurement
Counterparty exposure is the potential loss if a counterparty defaults on its obligations. Exposure measurement spans several dimensions, each capturing a different aspect of the risk.

**Current exposure (CE):** The mark-to-market value of all outstanding contracts with a counterparty. If the portfolio has positive market value to the firm, the firm has current exposure — the counterparty owes the firm money, and a default would result in a loss equal to that positive value. If the portfolio has negative market value to the firm, the firm has no current credit exposure to the counterparty (though the counterparty has exposure to the firm). Current exposure is calculated by revaluing all trades at current market prices.

```
CE = max(V, 0)
```

where V is the net mark-to-market value of all contracts with the counterparty (positive means the counterparty owes the firm).

**Potential future exposure (PFE):** The maximum expected exposure at a future date at a given confidence level (typically 95% or 97.5%). PFE accounts for the fact that even if current exposure is low, market movements could increase exposure significantly before the counterparty defaults. PFE is estimated using Monte Carlo simulation of risk factors (interest rates, FX rates, equity prices, credit spreads) that drive the value of the portfolio with the counterparty, or using parametric add-on methods.

Monte Carlo PFE simulation steps:
1. Identify the risk factors driving the value of each trade in the counterparty portfolio.
2. Simulate thousands of risk factor paths over the relevant time horizon (typically the life of the longest trade).
3. At each future time step, revalue the entire portfolio under each simulated scenario.
4. At each time step, compute the exposure as max(portfolio value, 0) for each scenario.
5. The PFE at a given time step is the exposure at the chosen confidence percentile (e.g., the 97.5th percentile across all scenarios).

The PFE profile — PFE plotted against time — shows how maximum expected exposure evolves over the life of the portfolio. PFE profiles typically rise as time horizon increases (more time for adverse market moves), then decline as trades mature and roll off.

**Expected exposure (EE):** The average exposure at a future date across all simulated scenarios. While PFE captures the tail risk, EE captures the central tendency. Expected positive exposure (EPE) is the time-averaged EE over a specified period, and it serves as the basis for regulatory capital calculations under the SA-CCR (Standardized Approach for Counterparty Credit Risk) and IMM (Internal Model Method) frameworks.

**Exposure at default (EAD):** The estimated exposure at the time of a counterparty default, used for regulatory capital calculations. Under SA-CCR:

```
EAD = alpha * (RC + PFE_addon)
```

where alpha = 1.4 (regulatory multiplier), RC = replacement cost (analogous to current exposure adjusted for collateral), and PFE_addon is a formulaic add-on based on trade notionals, asset class, and hedging sets.

**Regulatory capital context:** Banks are required to hold regulatory capital against counterparty credit risk. The capital charge is computed as EAD multiplied by the counterparty's risk weight (determined by external ratings or internal models under the IRB approach) multiplied by a capital ratio (typically 8% under Basel III). This creates a direct link between exposure measurement and the cost of trading: trades with high EAD or counterparties with poor credit quality consume more capital, making them more expensive. Credit Valuation Adjustment (CVA) risk — the risk of mark-to-market losses due to changes in counterparty credit spreads — is an additional capital charge introduced by Basel III that has further increased the capital cost of bilateral OTC derivatives.

**Wrong-way risk (WWR):** The risk that exposure to a counterparty increases when the counterparty's creditworthiness deteriorates. General wrong-way risk occurs when the counterparty's probability of default is positively correlated with general market risk factors. Specific wrong-way risk occurs when the structure of a transaction inherently creates the correlation — for example, writing a put option on a counterparty's own stock (if the stock falls, the option gains value to the firm, but the counterparty is also more likely to default). Wrong-way risk is difficult to model and requires explicit stress scenarios that jointly shock exposure and default probability.

### Credit Risk Assessment
Assessing a counterparty's creditworthiness is the foundation of counterparty risk management. The assessment combines external ratings, internal analysis, and market-implied indicators.

**External credit ratings:** Moody's, S&P, and Fitch provide credit ratings for major financial institutions and corporate counterparties. Ratings range from AAA/Aaa (highest quality) to D (default). For counterparty risk purposes, the key ratings are the long-term issuer credit rating and the short-term rating for settlement risk. Ratings provide a baseline assessment but are lagging indicators — they are updated infrequently and often reflect credit deterioration only after the market has already repriced the risk.

**Internal credit scoring:** Sophisticated trading desks maintain internal credit models that score counterparties based on financial statement analysis, qualitative factors, and peer comparison. Internal scores are updated more frequently than external ratings and can incorporate information that rating agencies may not weight heavily.

Key financial metrics for bank counterparties include: Common Equity Tier 1 (CET1) ratio (strong banks maintain CET1 above 12%), leverage ratio (Tier 1 capital to total exposure, minimum 3% under Basel III but well-capitalized banks target 5%+), liquidity coverage ratio (LCR, high-quality liquid assets to 30-day net cash outflows, minimum 100%), net stable funding ratio (NSFR, available stable funding to required stable funding, minimum 100%), and non-performing loan ratio (NPLs as a percentage of total loans, with rising NPLs signaling asset quality deterioration).

For corporate counterparties, relevant metrics include: debt-to-EBITDA ratio (leverage), interest coverage ratio (EBITDA to interest expense, with coverage below 2x signaling stress), current ratio (current assets to current liabilities), free cash