Counterparty and Credit Risk Management
Core concepts
Counterparty credit risk is the risk that a derivative counterparty defaults before settlement. Key measures: current exposure (mark-to-market), potential future exposure (PFE), credit valuation adjustment (CVA), wrong-way risk, and settlement risk. Mitigants include collateral/margin agreements (CSA), netting, thresholds, credit limits, and central clearing.
Mechanics
Under a CSA, parties post variation margin (against mark-to-market) and initial margin (against future moves). Netting reduces exposure across a portfolio to a single net amount. CVA is the market value of counterparty default risk-it reduces the fair value of a derivative asset. Wrong-way risk occurs when exposure increases as the counterparty's credit quality deteriorates (e.g., buying a put from a company whose stock you're hedging).
Traps in questions
- Confusing current exposure with PFE; PFE is forward-looking and probabilistic.
- Forgetting that netting only applies under enforceable master agreements.
- Missing wrong-way risk-exposure correlated with counterparty default.
- Treating CVA as a cost to the counterparty rather than a reduction in the asset's value to you.
Rule of thumb
Exposure = max(mark-to-market − collateral, 0), plus potential future exposure. Always ask: does my exposure grow if this counterparty weakens? If yes, that's wrong-way risk.
Worked example
Mark-to-market receivable = $8M; collateral posted = $5M; PFE = $2M. Current exposure = $3M; total exposure ≈ $5M. If the counterparty's credit spread widens, CVA rises and the fair value of the receivable falls.