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CRMM-11-defining-counterparty-credit-risk.html
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<title>Credit Risk Measurement and Management | Chapter 11 | Defining Counterparty Credit Risk</title>
<meta name="description" content="Financial Risk Manager Part 2 Study Materials">
<meta name="author" content="MacLane Wilkison">
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<h1>Chapter 11</h1>
<h3>Defining Counterparty Credit Risk</h3>
<p>
<small>Created for <a href="http://alchemistsacademy.com">Alchemists Academy</a> by <a href="http://alchemistsacademy.com/about">MacLane Wilkison</a></small>
</p>
</section>
<section>
<h2>Introduction</h2>
<p><em>Definition: The risk that a counterparty in a derivatives transaction will default prior to expiration of a trade and fail to make the required current and future payments</em></p>
<ul>
<li>The value of the underlying contract is uncertain both in magnitude and in direction</li>
</ul>
</section>
<section>
<h2>Components and Terminology</h2>
<ul>
<li>Credit exposure - loss in the event counterparty defaults</li>
<ul>
<li>Actual and potential claims</li>
</ul>
<li>Default probability and credit migration</li>
<li>Recovery rate - percentage of outstanding claims recovered</li>
<li>Mark-to-market - present value of all the payments to be received less those to be paid</li>
<li>Replacement cost</li>
</ul>
</section>
<section>
<h2>Controlling Counterparty Risk</h2>
<ul>
<li>Diversification - spreading exposure across different counterparties</li>
<li>Netting - offsetting positive and negative positions with the same counterparty</li>
<li>Collateralization - holding cash or securities against an exposure</li>
<li>Hedging - reducing exposure and counterparty risk via derivative instruments</li>
</ul>
</section>
<section>
<h2>Quantifying Counterparty Risk</h2>
<ul>
<li>Trade level - incorporates characteristics of the trade and associated risk factors</li>
<li>Counterparty level - incorporates risk mitigants for each counterparty</li>
<li>Portfolio level - considers the risk of all counterparties</li>
</ul>
</section>
<section>
<h2>Credit Exposure Metrics</h2>
<ul>
<li>Expected MtM - forward or expected value of a transaction at some point in the future</li>
<li>Expected exposure (EE)- positive MtM exposures</li>
<li>Potential future exposure (PFE)</li>
<li>Expected positive exposure (EPE) - the average expected exposure through time</li>
<li>Effective EPE - a non-decreasing EE</li>
<li>Maximum PFE - the peak PFE value over a time period</li>
</ul>
</section>
<section>
<h1>THE END</h1>
<h3><a href="http://alchemistsacademy.com">AlchemistsAcademy.com</a></h3>
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