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The collapse of Lehman Brothers in September The book takes a practical approach to C
Counterparty
2008 demonstrated what many in financial the essential elements with in-depth re
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markets had long feared: the failure of a large examination and analysis of methods it
financial institution, or even the imminent risk to measure, price and manage OTC R
of such failure, could cause counterparties to derivative counterparty risk. Four isk
incur severe losses as they scramble to cover sections focus on:
positions with the distressed institution.
Credit Risk
• Measurement and management
The cascade of losses in the aftermath of the • Pricing and hedging
demise of Lehman undermined markets across • Stress testing
the globe. Now, in the aftermath of the worst • Backtesting and risk capital
financial crisis in a generation, counterparty
credit risk has been widely identified as a blind Chapters from leading authorities
Measurement,
spot in risk management and risen to the top of such as Michael Pykhtin, Evan Picoult
the regulatory agenda. and the editor, Eduardo Canabarro,
Pricing and
explain key issues and provide a
Governments and supervisors around the practical toolkit for important areas
Hedging
world are focusing on the interconnectedness including:
of banks and systemic risk. Banks themselves
recognise that an active approach to this risk is • Calculating counterparty exposure
needed. • Collateral management
• Valuing collaterised derivatives EditEd by Eduardo Canabarro
Counterparty Credit Risk brings together leading • Stress testing
industry figures, regulators, academics, and • Backtesting and calculating
legal exports to provide the complete guide to economic capital
managing over-the-counter (OTC) derivative
counterparty credit risk. Counterparty Credit Risk is the essential E
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consultants, accountants, lawmakers, d
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PEFC Certified
This book has been
produced entirely from
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are accredited as PEFC
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Counterparty Credit Risk
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Counterparty Credit Risk
Measurement, Pricing and Hedging
Edited by Eduardo Canabarro
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Published by Risk Books, a Division of Incisive Financial Publishing Ltd
Haymarket House
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© 2009 Incisive Media.
ISBN 978-1-906348-34-2
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Contents
About the Editor vii
About the Authors ix
Introduction xvii
PART I: COUNTERPARTY RISK MEASUREMENT AND MANAGEMENT 1
1 Systemic Counterparty Credit Risk 3
Aaron Brown
AQR Capital Management
2 Collateralised Credit Exposure 17
Michael Pykhtin
Federal Reserve Board
3 Efficient Calculation of Counterparty Exposure Conditional on Default 51
David M. Rowe, Philip Koop and Daniel Travers
SunGard
4 Effective, Enterprise-wide Collateral Management 63
Darren Measures
JP Morgan
5 Evolution of the US Legal Framework for Counterparty Risk Mitigation 81
Lauren Teigland-Hunt
Teigland-Hunt LLP
PART II: COUNTERPARTY RISK PRICING AND HEDGING 107
6 Pricing and Hedging Counterparty Risk: Lessons Re-learned? 109
Eduardo Canabarro
Morgan Stanley
7 The Counterparty Risk of Credit Derivative Products 137
Jon Gregory
Ockham Financial Training and Consulting
8 Contingent Credit Default Swaps 165
Andrew P. Hollings, Shankar Mukherjee and Svein Stokke
Novarum Partners Ltd
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CounterParty Credit risk
9 Funding Benefit and Funding Cost 185
Yi Tang and Andrew Williams
Morgan Stanley
10 Generalised Valuation of Collateralised Derivatives 199
Patrick L. Chen, Katsuichiro Uchiyama and Guanghua Cao
Morgan Stanley
PART III: STRESS TESTING 219
11 Stress Testing and Scenario Analysis: Some Second Generation 221
Approaches
Greg Hopper
Goldman Sachs
12 Computing and Stress Testing Counterparty Credit Risk Capital 245
Dan Rosen; David Saunders
The Fields Institute for Research in Mathematical Sciences and R2 Financial
Technologies; University of Waterloo
PART IV: ECONOMIC AND REGULATORY CAPITAL 293
13 Back(testing) to the Future: From Market Risk to Counterparty Credit
Risk Models 295
Eduardo Epperlein; Sean Paul Hrabak; Wei Zhu, Alan Smillie
Citi; Financial Services Authority; Citi
14 Economic Capital for Counterparty Credit Risk from Two Perspectives 327
Evan Picoult
Citi and Columbia Business School
Index 351
vi
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about the editor
Eduardo Canabarro is the managing director responsible for quan-
titative risk management at Morgan Stanley. He is responsible
for the development of the methods and models used to measure
market and credit risks as well as for the independent review and
validation of pricing and risk models used by the bank. Prior to
Morgan Stanley, he held a similar position at Lehman Brothers as
managing director and global head of quantitative risk manage-
ment. Eduardo has also worked for Goldman Sachs and Salomon
Brothers in quantitative modelling and risk management.
Eduardo has published various articles in the Journal of Financial
Engineering, Journal of Fixed Income, The Journal of Risk Financing, The
Journal of Risk and Re-Insurance, and Risk. His articles “Counterpar-
ty Risk: Measurement and Pricing” and “Analyzing Counterparty
Risk” were cornerstones for the Basel II framework for regulatory
capital on counterparty credit risk. He has spoken at leading risk
management events around the world including the ones spon-
sored by the Wharton School, BIS, ICBI, Risk, PRMIA and IAFE.
Eduardo holds degrees in electrical engineering and an MBA (fi-
nance) from UFRGS Brazil as well as MS and PhD degrees in fi-
nance from University of California at Berkeley, US.
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about the authors
Aaron Brown is a risk manager at AQR Capital Management and
the author of The Poker Face of Wall Street (2006, picked as one of
the ten best books of 2006 by Business Week) and A World of Chance
(2008, with Reuven and Gabrielle Brenner). In his 27-year Wall
Street career, Aaron has been a portfolio manager, trader, head of
mortgage securities and risk manager for firms that include Mor-
gan Stanley and Citigroup; he also did a stint as a finance professor.
Aaron holds degrees in applied mathematics from Harvard and fi-
nance from the University of Chicago.
Guanghua Cao is a desk strategist for the Credit Valuation Adjust-
ment (CVA) Strategies Group in the Fixed Income Department at
Morgan Stanley, New York. His responsibilities include the devel-
opment of quantitative models for CVA valuation, hedging and
management. Prior to joining the CVA Strategies Group, Guanghua
was a quantitative analyst for the Credit Methodology Group at
Morgan Stanley, focusing on the validation of risk models and risk
monitoring. He holds a Masters in financial engineering from the
Haas School of Business, UC Berkeley, a PhD in applied mathemat-
ics from the Southern Methodist University and a BA in applied
mathematics from the Shanghai JiaoTong University.
Patrick Chen is currently the global head of the Model Review
Group at Morgan Stanley, where he is responsible for the inde-
pendent review and validation of pricing models and also for the
risk models used by the bank, as well as model risk measurement
methodology, development and reporting. Prior to joining Morgan
Stanley, Patrick has been the head of Counterparty Credit Risk &
CVA Analytics and head of Operational Risk Analytics at Lehman
Brothers. He has worked for Merrill Lynch, Barclays Capital and
Bank of America in various trading desk and quantitative risk man-
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