Counterparty Credit Risk Exposure Measurement

An Introduction
Dante Lomibao
May 2011
® Dante Lomibao – May 2011 2
Outline


Fundamental Concepts in Credit Risk Measurement


What is Credit Risk?


Components of Credit Risk


Market Risk vs. Credit Risk


Counterparty Exposure Measurement


Evolution of Counterparty Exposure Measurement Techniques


The Nature of Counterparty Credit Risk


Potential Future Exposure (PFE) Probability Distribution


How PFE Evolves Over Time


Traditional Approaches in Mitigating Counterparty Credit Risk


Credit Valuation Adjustment (CVA)


What is CVA


Calculating Unilateral CVA


Calculating Bilateral CVA


Credit Risk Capital


What is Credit Risk Capital


Basel II Capital
Fundamental Concepts in Credit Risk Measurement
® Dante Lomibao – May 2011 4
What is Credit Risk?


What is Credit Risk?


Credit Risk represents the volatility (uncertainty) of losses due to credit events such as default or rating
downgrades


Types of Credit Risks
Lending Risk


Borrower Defaults


Loan value decreases because of


Decrease in credit quality of borrower


Increase in general credit spread
Issuer Risk


Issuer of security defaults


Security’s market value decreases because of


Decrease in credit quality of borrower


Increase in general credit spread
Counterparty Risk


Counterparty defaults


In an exchange, we pay but do not receive (Settlement Risk)


Counterparty defaults before settlement and contract has positive value
to us


Market value of counterparty risk has increased because of


Increase in the credit spread of the counterparty relatively to us


Increase in counterparty exposure relative to its exposure to us
® Dante Lomibao – May 2011 5
Components of Credit Risk


Exposure


Amount that we can lose as a result of counterparty or borrower default


Exposure is dynamic for market-traded instruments


Credit Worthiness


Probability of Default – the likelihood that a borrower/counterparty will default


Credit Rating Migration – Potential loss may occur when a borrower/counterparty migrates to a lower
rating as PV of positions are discounted at higher risky rates


Loss Severity (Loss Given Default)


In the event of default, the amount that we are likely to lose


LGD = 1 – Recovery Rate
Exposure Distribution Default Distribution Recovery Distribution
Joint Distribution
Loss Distribution
=
Credit Loss Distribution
( ) ( ) ( ) ( ) ( )
1
max , 0 0, 1 0,
n
p i i i
i
L t X t d t t B t o
=
( ( = ÷
¸ ¸ ¸ ¸
¿
® Dante Lomibao – May 2011 6
Credit Exposure


Current Exposure


Current replacement cost (amount that we can lose if the counterparty defaulted today)


For loan products, this is the loan principal plus accrued interest rates


For traded products, this is the current mark-to-market of the counterparty’s portfolio


Potential Future Exposure
Estimate of future replacement cost (amount that we can lose if the counterparty defaulted at some
time in the future)


Worst Case Exposure (Confidence Level Exposure)
The maximum amount that we can lose as a result of counterparty default at a given time and
confidence level


Peak Exposure
The largest worst-case exposure across time up to he maturity of the longest contract in the
counterparty’s portfolio


Expected Exposure
Average amount that we can lose at a given time as a result of counterparty default


Settlement Exposure
Risk that a settlement in a transfer system does not take place as expected.


Happens when one party defaults on its clearing obligations to one or more counterparties.


Settlement risk comprises both credit and liquidity risks.
® Dante Lomibao – May 2011 7
Market Risk vs. Credit Risk


Market Exposure


Potential loss in market value of position if market risk factor goes against our position.


Example: If we are net long 100 shares of MSFT at $26 and the price goes to $20 a share, then we have
a market loss of $600


Credit Exposure


Potential loss if our aggregated position with a counterparty has a positive PV and the counterparty
defaults.


Example: Assume we bought a MSFT call option on 100 shares from counterparty ABC at $26 strike. If
MSFT moves to $30 a share and the counterparty defaults, we can potentially lose $400, assuming no
recovery from counterparty ABC
Attribute Market Risk Credit Risk
Time Horizon


Short-Term risk
(1-10 days)


Single Step


Long-Term Risk
(Up to the longest tenor in a counterparty’s portfolio since peak exposure
may occur several years into the future)


Multi-Step
Nature of Loss 

Adverse Market Move 

Loss is contingent on counterparty defaulting when we have trading gains
Distribution


~ Normal (Usually
approximated as normal)


Large Negative Skew
Arises from significant (although small) probability of a large loss
Risk Mitigation


Matching Positions
Risk can be eliminated
by offsetting positions
 Use of Netting Agreements
 Collateral Groups
 Mutual Terminations
 Obligor Diversification
Legal Issues


Realization not dependent on
legal issues
 Magnitude of risk is affected by enforceability of netting agreements
® Dante Lomibao – May 2011 8
Market Risk vs. Credit Risk
0
5
10
15
20
25
30
35
40 50 60 70 80 90 100 110 120 130
Bond Price ($)
P
r
o
b
a
b
i
l
i
t
y

(
%
) Actual Normal Approximation
Distribution of prices of a 10-yr BBB rated corporate bond driven by credit events
Distribution of prices of a 10-yr BBB rated corporate bond (Semi-Annual Coupon of 7.5%)
Rating
Transition 
Prob
Spread (bp)
Bond
Price
AAA 0.02% 5 110.0
AA 0.33% 10 109.6
A 5.95% 20 108.9
BBB 86.93% 50 106.7
BB 5.30% 200 96.8
B 1.17% 400 85.4
CCC 0.12% 1,000 60.2
D 0.18% 44.1
0
5
10
15
20
25
30
35
40
40 50 60 70 80 90 100 110 120 130
Bond Price ($)
P
r
o
b
a
b
i
l
i
t
y

(
%
)
Actual
Normal Approximation
BBB
Default CCC B BB A AA AAA
Recovery Rate
® Dante Lomibao – May 2011 9
Probability of Default and Credit Migration


S&P One-Year Transition Matrix
Average Annual Transition Probabilities (1981-2010) Average Annual Transition Probabilities (2008-2009)
AAA AA A BBB BB B CCC/C D AAA AA A BBB BB B CCC/C D
AAA 90.89 8.33 0.56 0.06 0.08 0.03 0.06 0.00 AAA 88.96 7.36 1.84 0.00 0.00 0.61 1.23 0.00
AA 0.60 90.16 8.50 0.56 0.06 0.08 0.02 0.02 AA 0.00 81.26 17.68 0.64 0.11 0.00 0.11 0.21
A 0.04 2.00 91.66 5.64 0.40 0.17 0.02 0.08 A 0.00 0.90 91.36 6.76 0.47 0.24 0.00 0.27
BBB 0.01 0.14 3.94 90.55 4.26 0.69 0.16 0.24 BBB 0.00 0.00 2.50 91.27 4.96 0.58 0.22 0.47
BB 0.02 0.05 0.18 5.78 84.05 8.06 0.83 1.03 BB 0.00 0.06 0.00 4.48 82.76 10.99 0.88 0.83
B 0.00 0.05 0.16 0.26 6.18 83.13 5.07 5.15 B 0.00 0.00 0.04 0.09 3.31 79.86 9.23 7.46
CCC/C 0.00 0.00 0.22 0.33 0.99 15.33 51.92 31.21 CCC/C 0.00 0.00 0.00 0.00 0.00 8.93 41.96 49.11
I
n
i
t
i
a
l
 
R
a
t
i
n
g
1 2 3 4 5 10 15 20 25
AAA 0.00 0.03 0.12 0.23 0.33 0.86 1.20 1.80 3.19
AA 0.02 0.06 0.13 0.23 0.34 0.92 1.36 2.48 5.87
A 0.08 0.20 0.36 0.54 0.73 2.07 3.30 6.36 9.09
BBB 0.24 0.73 1.27 1.99 2.74 6.43 10.63 14.71 18.23
BB 1.03 3.18 5.83 8.43 10.93 22.67 30.61 40.90 44.00
B 5.15 11.97 18.28 23.68 27.93 43.03 53.73 61.16 66.44
CCC/C 31.21 42.07 48.46 52.51 56.66 66.45 70.58 73.04 73.04
Investment Grade 0.12 0.35 0.61 0.95 1.29 3.03 4.64 7.08 9.99
Speculative Grade 4.74 9.55 14.08 18.01 21.33 34.10 42.77 51.38 55.23
All Rated 1.67 3.34 4.88 6.21 7.32 11.40 14.06 17.17 20.02
Years


Cumulative Default Rates


Historical Default Rates
0
10
20
30
40
50
60
70
80
0 5 10 15 20 25
Years
D
e
f
a
u
l
t
 
R
a
t
e
 
(
%
)
A
BBB
BB
B
CCC/C
AA
0.0%
1.0%
2.0%
3.0%
4.0%
5.0%
1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009
D
e
f
a
u
l
t
 
R
a
t
e
Credit Downturns
Counterparty Exposure Measurement
® Dante Lomibao – May 2011 11
The Nature of Counterparty Credit Risk
Counterparty risks…


are by-product of privately-negotiated derivatives transactions


create a chain of dependencies among derivatives counterparties


lead to exposures that must be measured and managed
Bank Corp B
Swap Rate
2
Libor + Spread
2
Corp A
Swap Rate
1
Libor + Spread
1
Default!!!!
Bank’s exposure to Corporation B


Counterparty B defaults, LIBOR goes up and the swap has positive MTM to the Bank


Since the Bank receives Libor + Spread (pays Fixed), the replacement value of the swap increases
Bank’s exposure to Corporation A


Counterparty A defaults, LIBOR goes down and the swap has positive MTM to the Bank


Since the Bank receives a fixed rate (pays Libor + Spread), the replacement value of the swap increases
® Dante Lomibao – May 2011 12
The Nature of Counterparty Credit Risk
Cash Flows in the Event of Default
Bank’s Loss on Default = (1 – o) ×

max(0, PV
risk-free
)
Expected Loss: EL(swap) = PV
risk-free
(swap) – PV
risky
(swap)
To compensate for EL: PV
risk-free
(swap+ S) = PV
risky
(swap)
0 s

o s

1 the Recovery Rate
Corp B defaults
PV
risk-free
>

0 (Bank’s PV)
Bank Receives o ×

PV
risk-free
Bank’s Loss = (1 – o) ×

PV
risk-free
PV
risk-free
>

0 (Bank’s PV)
PV
risk-free
s

0 (Bank’s PV)
Bank Pays PV
risk-free
Bank’s Loss = 0
PV
risk-free
s

0 (Bank’s PV)
Corp B Bank
Swap Rate
Libor + S
® Dante Lomibao – May 2011 13
Difference Between Lending and Counterparty Credit Risk


The market value of a derivative contract (e.g. swap or forward) with a counterparty
could potentially be positive or negative


Unlike loan wherein the Lender has only the exposure to the Borrower


In counterparty risk, either parties can have exposure to the other depending on the future state
of the market


The magnitude of counterparty exposure depends on the uncertain future state of the
market


For most loans, there is less uncertainty in the magnitude of future exposure and very close to
the notional for bullet loans


Counterparty exposures could only be described statistically


For large dealers, the exposures from various trades may offset each other at given
states of the market


For lending products, all loans add to the exposure at all times
® Dante Lomibao – May 2011 14
Evolution of Exposure Measurement Techniques


Notional Approach – Exposure equals notional amount


Ignores the market value of the positions


Ignores the volatilities and correlations between market factors that determine the exposure


Static Factor – Exposure is equal to Notional x Factor


Constant factor does not change with life of trade nor with the granularity of trade types


Ignores the current mark-to-market of trades


MTM + Add-On – Exposure is equal to MTM plus add-on determined by the notional x factor


Although MTM is dynamic, the add-on is still static


Monte-Carlo Simulation


Considers the volatilities and correlations of various risk factors that determine the exposure
Notional Amount
Static Factor
Dynamic (MTM + Add-On)
Monte-Carlo Simulation
I
n
c
r
e
a
s
i
n
g

C
o
m
p
l
e
x
i
t
y
1980’s 1990’s 1990’s
® Dante Lomibao – May 2011 15
Probability Distribution of Potential Future Exposure
Credit exposure is asymmetric with the underlying market factor (rate, price, index, etc.). Market factor
movements causing negative MTM do not result in credit exposure.
Potential Future Exposure
(at the 1-year simulation point)
MTM
(Current
Exposure)
today t = 1 yr.
P
o
r
t
f
o
l
i
o

V
a
l
u
e
95
th
Percentile Exposure
(PE95)
Time
Expected Positive Exposure
(EPE)
5
th
Percentile Exposure
Past
• Only outcomes in the shaded area result in exposure
• EPE is the average of the non-negative exposures. If there are 1,000 simulation paths, then
EPE = Sum{max[0,Exposure(i)]}/1000
• PE95 is the 95
th
percentile exposure, i.e., the 950
th
largest exposure
® Dante Lomibao – May 2011 16
Simulation of Portfolio Potential Future Exposure
Today
Past
Today 2 Yr Past
Possible 

paths of 

6M USD 

Libor
6
M

$

L
i
b
o
r
Today 2 Yr Past
Possible 

paths of 

JPY/USD 

FX Rate
J
P
Y
/
U
S
D
Possible 

paths of 

Portfolio PV
P
F
E

(
$
)
2 Yr
Revalue portfolio using 

simulated values of USD 

Libor and JPY/USD rates
Simulate Paths of Market Factors.
Apply Historical Covariance E
Potential Future Exposure
95% Confidence‐Level
® Dante Lomibao – May 2011 17
Counterparty Exposure Profile
Worst Case Exposure
Expected Exposure
P
o
r
t
f
o
l
i
o

V
a
l
u
e
95% Confidence
Level
Peak Exposure
Credit Limit
Time t
® Dante Lomibao – May 2011 18
Calculating the Exposure Metrics
Max(-378,0) + Max(-2677,0) = 0
-378 + -2677 = -3,055
Average(V
1,1
…V
1,20
)
Sum{Max(V
1,1
,0)+….+ Max(V
1,20
,0)}
95
th
Percentile Exposure
(19
th
Largest Exposure out of 20)
Trade 1 Trade 2 Discount Rate Tenor
Receive Fix Receive Fix 4% 1 year
No. of Barrels 1,000 2,000
Fixed Price 11 10
Maturity (Yr.) 1 1
Scenario #
Simulated Oil 
Price
Scenario # Trade 1 Trade 2
T1 + T2 
(W/O Netting)
T1 + T2 
(With Netting)
1 10.6 1 369 ‐1,183 369 ‐814
2 9.1 2 1,848 1,774 3,622 3,622
3 10.7 3 303 ‐1,316 303 ‐1,013
4 9.1 4 1,784 1,646 3,430 3,430
5 9.7 5 1,215 508 1,723 1,723
6 8.2 6 2,735 3,548 6,282 6,282
7 11.4 7 ‐378 ‐2,677 0 ‐3,055
8 11.4 8 ‐392 ‐2,706 0 ‐3,098
9 8.8 9 2,159 2,396 4,555 4,555
10 10.6 10 364 ‐1,193 364 ‐829
11 9.4 11 1,556 1,190 2,746 2,746
12 10.1 12 848 ‐225 848 623
13 10.3 13 710 ‐502 710 208
14 10.0 14 991 60 1,051 1,051
15 10.7 15 321 ‐1,280 321 ‐959
16 9.9 16 1,087 252 1,339 1,339
17 11.8 17 ‐728 ‐3,378 0 ‐4,107
18 8.9 18 1,982 2,042 4,023 4,023
19 11.7 19 ‐656 ‐3,233 0 ‐3,889
20 9.2 20 1,749 1,577 3,326 3,326
Average 10.1 893 ‐135 1,751 758
1,001 750 1,751 1,646
2,159 2,396 4,555 4,555 Potential Future Exposure (PE95)
Expected Exposure
Expected Positive Exposure
EPE without Netting >

EPE with Netting
Bank has two one-year forward
trades with a Counterparty:
Trade 1
Bank Receives a Fix Price of $11
per barrel of oil and pays floating
price for 1000 barrels
Trade 2
Bank Receives a Fix Price of $10
per barrel of oil and pays floating
price for 2,000 barrels
® Dante Lomibao – May 2011 19
How Potential Future Exposure Evolves Over Time
Diffusion and Amortization


Diffusion


As time passes, the “diffusion effect” tends to increase exposure since there is greater potential for
rates to move away from current levels


Amortization


As time goes by, the “amortization effect” tends to decrease exposure as periodic payments are made
reducing the remaining cash-flow that is exposed to default


For single cash-flow products (e.g., FX Forward), there is no “amortization” effect since cash-flow
occurs only at maturity date. Exposure is purely due to diffusion.
There are two main factors that determine how the potential future exposure varies with time:
diffusion and amortization
Di f f u si o n o f I n t e r e st Ra t e
4. 5%
5. 0%
5. 5%
6. 0%
6. 5%
7. 0%
7. 5%
0 1 2 3 4 5
Yea r s i n Fu t u r e
P
o
t
e
n
t
i
a
l

I
n
t
.

R
a
t
e
Fl a t Yi e l d Cu r v e = 5 %
Vo l a t i l i t y = 1 0 %
Po t e n t i a l Ex p o su r e o f a n FRA
0. 0%
0. 5%
1. 0%
1. 5%
2. 0%
2. 5%
0 1 2 3 4 5
Year s i n Fu t u r e
P
o
t
e
n
t
i
a
l

E
x
p
o
s
u
r
e

(
%

o
f

N
o
t
i
o
n
a
l
)
95% Confidence-Level
Interest Rate
95% Confidence-Level
Potential Future Exposure
® Dante Lomibao – May 2011 20
How Potential Future Exposure Evolves Over Time
Multiple Cash-Flow Product
Time
(years)
Projected
Rates - 95%
Confidence
(%)
Diffusion
(Potential Change in
Interest Rate)
(In Basis Pts)
Amortization
(Remaining
Cash Flows)
Diffusion ×

Amortization
(%)
Potential Future
Exposure
(% of Notional)
0.00 5.00 0 5 0.0 0.0
0.25 5.87 87 5 4.3 3.7
0.50 6.25 125 5 6.3 5.4
1.00 6.82 182 5 9.1 8.0
1.50 7.27 227 4 9.1 7.9
2.00 7.66 266 4 10.6 9.5
2.50 8.01 301 3 9.0 8.0
3.00 8.34 334 3 10.0 9.2
3.50 8.64 364 2 7.3 6.7
4.00 8.93 393 2 7.9 7.5
4.50 9.20 420 1 4.2 4.0
5.00 9.46 446 1 4.5 4.5
Example
5-Year Interest Rate Swap Pay Fix 5%
Payment Frequency: Annual
Yield Curve (Flat): 5%
Interest Rate Volatility: 20%
Confidence Level: 95%
| | t t R t R o o 65 . 1 exp ) 0 ( ) (
2
2
1
+ ÷ =
We assume interest rates evolve according to:
Amortization

1
2
3
4
5
6
0 1 2 3 4 5
Years in the Future
R
e
m
a
i
n
i
n
g
 
C
a
s
h
 
F
l
o
w
s
Interest Rate Diffusion

0.5
1.0
1.5
2.0
2.5
3.0
3.5
4.0
4.5
5.0
0 1 2 3 4 5
Years in the Future
I
n
t
e
r
e
s
t
 
R
a
t
e
 
C
h
a
n
g
e
 
(
B
.
P
.
)
Diffusion x Amortization
0%
2%
4%
6%
8%
10%
12%
0 1 2 3 4 5
Years in the Future
R
e
m
a
i
n
i
n
g
 
C
a
s
h
 
F
l
o
w
s
Potential Exposure
0%
2%
4%
6%
8%
10%
12%
0 1 2 3 4 5
Years in the Future
R
e
m
a
i
n
i
n
g
 
C
a
s
h
 
F
l
o
w
s
® Dante Lomibao – May 2011 21
Potential Future Exposure Profiles of Derivative Products
Payer Interest Rate Swap
Interest Rate Cap Currency Swap
Receiver Interest Rate Swap
Recei v er Swap
-
50, 000
100, 000
150, 000
200, 000
250, 000
0 5 10 15 20
Ti me Bucket ( y r s)
E
x
p
o
s
u
r
e

(
U
S
D
)
20-Yr Swap
15-Yr Swap
10-Yr Swap
5-Yr Swap
Effect of Maturity
0
50
100
150
200
250
300
0 2 4 6 8 10
Time Horizon
E
x
p
o
s
u
r
e
 
(
$
'
0
0
0
)
Expected Posi ti ve Exposure
95% Confi dence PFE
Notional Amount = $1 Million
0
50
100
150
200
250
300
0 2 4 6 8 10
Time Horizon
E
x
p
o
s
u
r
e
 
(
$
'
0
0
0
)
Expected Posi ti ve Exposure
95% Confi dence PFE
Notional Amount = $1 Million
0
100
200
300
400
500
600
700
800
0 2 4 6 8 10
Time Horizon
E
x
p
o
s
u
r
e
 
(
$
'
0
0
0
)
Expected Posi ti ve Exposure
95% Confi dence PFE
Notional Amount = $1 Million
0
50
100
150
200
250
300
350
0 2 4 6 8 10
Time Horizon
E
x
p
o
s
u
r
e
 
(
$
'
0
0
0
)
Expected Posi ti ve Exposure
95% Confi dence PFE
Notional Amount = $1 Million
® Dante Lomibao – May 2011 22
Evolution of Interest Rates and Potential Future Exposure
AR
up
AR
down
0.0%
2.0%
4.0%
6.0%
8.0%
10.0%
0 1 2 3 4 5
Time Bucket (Years)
I
n
t
e
r
e
s
t
 
R
a
t
e
 
L
e
v
e
l
Upper Interest Rate Band
Lower Interest Rate Band
Base Rate
AR
up
AR
down
0.0%
2.0%
4.0%
6.0%
8.0%
10.0%
0 1 2 3 4 5
Time Bucket (Years)
I
n
t
e
r
e
s
t
 
R
a
t
e
 
L
e
v
e
l
Upper Interest Rate Band
Lower Interest Rate Band
Base Rate


Asymmetry Between the Upper and Lower Confidence Bands


Using a lognormal assumption, the upper confidence band of the interest rate distribution diffuses more
than the lower band


This results in a Payer Interest Rate Swap (Bank Pays Fix and Receives Floating Rate) resulting in a
larger exposure than a Receiver Interest Rate Swap (Bank Receives Fix and Pays Floating Rate)
-

In a Payer Swap the Bank has counterparty risk when interest rate goes up since the value of the swap to the
Bank increases. The reverse is true for Receiver Swap.
Interest Rate Evolution – 95% Confidence Interval (20% Volatility) Interest Rate Evolution – 95% Confidence Interval (30% Volatility)
® Dante Lomibao – May 2011 23
Risk Factor Evolution
Single Factor Interest Rate Curve
3. 5%
4. 0%
4. 5%
5. 0%
5. 5%
6. 0%
0 1 2 3 4
Ye a r s
1
-
Y
r

R
a
t
e

(
%
)
3. 5%
4. 0%
4. 5%
5. 0%
5. 5%
6. 0%
0 1 2 3 4
Yea r s
1
-
Y
r

R
a
t
e

(
%
)
3. 5%
4. 0%
4. 5%
5. 0%
5. 5%
6. 0%
0 1 2 3 4
Ye a r s
1
-
Y
r

R
a
t
e

(
%
)
Possible shapes of 1-yr Forward Rates
r
1
r
2
r
3
r
4
R
1
(zo
1
)
R
2
(zo
2
)
R
3
(zo
3
) R
4
(zo
4
)
R
1
(-zo
1
)
R
2
(-zo
2
)
R
3
(-zo
3
)
R
4
(-zo
4
)
R
1
(zo
1
)= r
1
exp[ -0.5 o
2
+ z o
1
]
• In single-factor model, we use the same
random number z for all parts of the curve.
• The random number z determines the
direction of the curve.
• When z is positive, the whole curve shifts up
and shifts down when z is negative.
® Dante Lomibao – May 2011 24
Risk Factor Evolution
Single-Factor vs. Multi-Factor Interest Rate Curve
Possi bl e Out comes of t he 3- Mont h For war d
I nt er est Rat e Cur v e ( One- Fact or )
( 5 Year s i nt o t he Fut ur e)
0%
2%
4%
6%
8%
10%
0 5 10 15 20 25 30 35
Tenor ( Year s)
F
o
r
w
a
r
d

R
a
t
e

(
%
)
S1 S2 S3 S4 S0
Possi bl e Out comes of t he 3- Mont h For war d
I nt er est Rat e Cur v e ( Thr ee- Fact or s)
( 5 Year s i nt o t he Fut ur e)
0%
2%
4%
6%
8%
10%
0 5 10 15 20 25 30 35
Te n o r ( Ye a r s)
F
o
r
w
a
r
d

R
a
t
e

(
%
)
S1 S2 S3
S4 S0
( ) ( ) ( )
( )
3 3
2
1 1
1
0 exp
2
i i i i i
k k k k
i i
F t F z t PC t PC o o
= =
| |
= · · ÷ ·
|
|
\ .
¿ ¿
( ) ( )
2
1
2
0 exp
k k k k
F t F t z t o o
(
= ÷ +
¸ ¸
® Dante Lomibao – May 2011 25
Risk Factor Evolution
Multi-Factor Interest Rate Curve
3. 5%
4. 0%
4. 5%
5. 0%
5. 5%
6. 0%
0 1 2 3 4
Yea r s
1
-
Y
r

R
a
t
e

(
%
)
3.5%
4.0%
4.5%
5.0%
5.5%
6.0%
0 1 2 3 4
Ye a r s
1
-
Y
r

R
a
t
e

(
%
)
Possible shapes of 1-yr Forward Rates
r
1
r
2
r
3
r
4
R
1
(z
1
o
1
)
R
2
(z
2
o
2
)
R
3
(-z
3
o
3
)
R
4
(-z
4
o
4
)
R
1
(-z
1
o
1
)
R
2
(-z
2
o
2
)
R
3
(z
3
o
3
)
R
4
(z
4
o
4
)
R
1
(z
1
o
1
)= r
1
exp[-0.5o
1
2
+ z
1
o
1
]
• The random numbers z
i
's determine the
direction of the curve.
• In multi-factor model, we use different
z
i
's for each part of the curve.
• When z
i
is positive, the particular
forward rate shifts up and shifts down
when z
i
negative.
3. 5%
4. 0%
4. 5%
5. 0%
5. 5%
6. 0%
0 1 2 3 4
Yea r s
1
-
Y
r

R
a
t
e

(
%
)
® Dante Lomibao – May 2011 26
Traditional Approaches in Mitigating Counterparty Credit Risk
Trade Number
Time Bucket (Years)
0 1 2 3 4 5
Trade 1 -1.2 -1.0 2.5 3.0 1.2 -1.4
Trade 2 2.6 3.0 3.5 2.0 4.0 5.0
Trade 3 1.5 -0.3 -1.7 1.3 2.7 1.9
Trade 4 -2.7 -2.5 -1.1 -3.1 1.0 1.3
Trade 5 1.0 -1.5 2.0 1.5 0.6 2.0
Exposure
Without Netting 5.1 3.0 8.0 7.8 9.5 10.2
With Netting 1.2 -2.3 5.2 4.7 9.5 8.8
Exposure (w/ Netting) 1.2 0.0 5.2 4.7 9.5 8.8
Collateral and Exposure
Collateral Account* 1.0 -2.0 5.0 4.5 9.0 8.0
Exposure (w/ Netting & Collateral) 0.2 -0.3 0.2 0.2 0.5 0.8
Sample Path of Counterparty’s Exposures


Netting


ISDA Master Agreement


Allows negative and positive exposure to
cancel each other in the event of default


Enforceability of the close-out netting
provisions is crucial


Credit Enhancements


Collateral Agreements (Credit Support
Annex – CSA)


Early Termination Agreements (Derivatives
contracts are terminated prior to their
contractual settlement date, usually
triggered by events of default)


Guarantees (Third-Party of Parent
Guarantee)


Embedded Option to Cancel or Shorten
Maturity (Liquidity Puts, Credit Triggers
etc.)


Exposure Limits


Confidence-Level Potential Exposure Limit
(PE95) or Net Current Exposure Limit


Usually dependent on the credit quality of
the counterparty
* Positive number means that we hold the collateral and negative means that we provide collateral to counterparty.
‐2
0
2
4
6
8
10
12
0 1 2 3 4 5
Time Bucket (Years)
E
x
p
o
s
u
r
e
 
(
$
M
M
)
Wi thout Netti ng
Exposure (w/
Netti ng)
Exposure (w/ Netti ng
& Col l ateral )
® Dante Lomibao – May 2011 27
Impact of Collateral on Exposure
Unsecured 
Threshold
Collateral C
0
Minimum
Transfer 

Amount
Margin Call Lag
MTM
0
MTM
1
C
0
C
1
Exposure 

without 

Collateral
Exposure with 

Collateral
Unsecured 
Threshold
Collateral C
0
Margin Call Lag
MTM
0
MTM
1
C
0
Exposure 

without 

Collateral
Exposure with 

Collateral
Minimum
Transfer 

Amount
DAY 0
DAY 5
Exposure without Collateral
Exposure with Collateral
-
5
10
15
20
25
30
0 5 10 15 20 25 30 35 Days
E
x
p
o
s
u
r
e
(
U
S
D
)
Exp. w/o Coll Exp. w/ Coll Threshold
DAY 0 to Day 5
Time Profile with Collateral
® Dante Lomibao – May 2011 28
Counterparty Exposure Calculation Process
Years HKD KRW SGD TWD
0.5 33. 48 12. 38 66. 85 14. 92
1.0 32. 49 19. 18 40. 88 22. 42
1.5 31. 56 22. 97 31. 96 23. 13
2.0 30. 67 24. 42 27. 63 23. 18
2.5 29. 84 24. 89 25. 18 23. 18
3.0 29. 05 25. 03 23. 68 23. 18
3.5 28. 30 25. 07 22. 70 23. 18
4.0 27. 59 25. 09 22. 05 23. 18
4.5 26. 91 25. 09 21. 61 23. 18
5.0 26. 27 25. 09 21. 30 23. 18
5.5 25. 66 25. 09 21. 08 23. 18
Years HKD KRW SGD TWD
0. 5 33.48 12. 38 66.85 14. 92
1. 0 32.49 19. 18 40.88 22. 42
1. 5 31.56 22. 97 31.96 23. 13
2. 0 30.67 24. 42 27.63 23. 18
2. 5 29.84 24. 89 25.18 23. 18
3. 0 29.05 25. 03 23.68 23. 18
3. 5 28.30 25. 07 22.70 23. 18
4. 0 27.59 25. 09 22.05 23. 18
4. 5 26.91 25. 09 21.61 23. 18
5. 0 26.27 25. 09 21.30 23. 18
5. 5 25.66 25. 09 21.08 23. 18
Years HKD KRW SGD TWD
0.5 33.48 12.38 66. 85 14. 92
1.0 32.49 19.18 40. 88 22. 42
1.5 31.56 22.97 31. 96 23. 13
2.0 30.67 24.42 27. 63 23. 18
2.5 29.84 24.89 25. 18 23. 18
3.0 29.05 25.03 23. 68 23. 18
3.5 28.30 25.07 22. 70 23. 18
4.0 27.59 25.09 22. 05 23. 18
4.5 26.91 25.09 21. 61 23. 18
5.0 26.27 25.09 21. 30 23. 18
5.5 25.66 25.09 21. 08 23. 18
Market Data / Parameter Calibration Correlated Market Scenarios
Simulated Market
Scenario
(Interest Rates, FX
Rates, Credit
Spreads,
Commodities, etc.)
Valuation
- Full Revaluation
- P&L Grids
- Taylor Expansion
- Notional Factors
Prd Deal Id Inst Desc Trade Date
COM 21846 Fixed/Float Swap 2-Oct-2002
COM 21949 Fixed/Float Swap 7-Oct-2002
COM 21956 Fixed/Float Swap 4-Oct-2002
COM 21958 Fixed/Float Swap 4-Oct-2002
COM 23222 Fixed/Float Swap 25-Oct-2002
COM 23224 Cap 25-Oct-2002
COM 23225 Floor 25-Oct-2002
COM 23226 Bermudan Swaption 25-Oct-2002
COM 23233 Power Financial Swap 25-Oct-2002
Prd Deal Id Inst Desc Trade Date
COM 21846 Fixed/Float Swap 2-Oct-2002
COM 21949 Fixed/Float Swap 7-Oct-2002
COM 21956 Fixed/Float Swap 4-Oct-2002
COM 21958 Fixed/Float Swap 4-Oct-2002
COM 23222 Fixed/Float Swap 25-Oct-2002
COM 23224 Cap 25-Oct-2002
COM 23225 Floor 25-Oct-2002
COM 23226 Bermudan Swaption 25-Oct-2002
COM 23233 Power Financial Swap 25-Oct-2002
Prd Deal Id Inst Desc Trade Date
COM 21846 Fixed/Float Swap 2-Oct-2002
COM 21949 Fixed/Float Swap 7-Oct-2002
COM 21956 Fixed/Float Swap 4-Oct-2002
COM 21958 Fixed/Float Swap 4-Oct-2002
COM 23222 Fixed/Float Swap 25-Oct-2002
COM 23224 Cap 25-Oct-2002
COM 23225 Floor 25-Oct-2002
COM 23226 Bermudan Swaption 25-Oct-2002
COM 23233 Power Financial Swap 25-Oct-2002
Simulated PV’s
Aggregation
- Collateralized
- Credit Lines and
Availability
- Other Credit
Mitigations
Trade Data
CSD# BAMTA CPMTA BATHRESHOLDCPTHRESHOLD
14567 1,000,000 500,000 50,000,000 20,000,000
34567 2,000,000 1,000,000 40,000,000 15,000,000
54789 500,000 100,000 20,000,000 10,000,000
46782 1,000,000 500,000 100,000,000 50,000,000
1120 500,000 500,000 30,000,000 25,000,000
3672 500,000 500,000 25,000,000 20,000,000
12567 1,000,000 500,000 100,000,000 50,000,000
CSD# BAMTA CPMTA BATHRESHOLDCPTHRESHOLD
14567 1,000,000 500,000 50,000,000 20,000,000
34567 2,000,000 1,000,000 40,000,000 15,000,000
54789 500,000 100,000 20,000,000 10,000,000
46782 1,000,000 500,000 100,000,000 50,000,000
1120 500,000 500,000 30,000,000 25,000,000
3672 500,000 500,000 25,000,000 20,000,000
12567 1,000,000 500,000 100,000,000 50,000,000
CSD# BAMTA CPMTA BATHRESHOLDCPTHRESHOLD
14567 1,000,000 500,000 50,000,000 20,000,000
34567 2,000,000 1,000,000 40,000,000 15,000,000
54789 500,000 100,000 20,000,000 10,000,000
46782 1,000,000 500,000 100,000,000 50,000,000
1120 500,000 500,000 30,000,000 25,000,000
3672 500,000 500,000 25,000,000 20,000,000
12567 1,000,000 500,000 100,000,000 50,000,000
Netting, Collateral, Referential Data Exposure Distributions
Analytic Tools
- Limit Monitoring
- CVA
- Economic Capital
- Stress
- Regulatory Capital
Pricing Counterparty Risk
The Credit Valuation Adjustment (CVA)
® Dante Lomibao – May 2011 30
What is Credit Valuation Adjustment (CVA)?


CVA is the market value of the credit risk due to counterparty default


It is equal to the Net Present Value of expected future credit losses due to counterparty default


CVA = PV { (Expected Positive Exposure) ×

(Credit Spread) }


CVA is sensitive to both the exposure and the 2 counterparties credit spreads


Adjustment can be positive or negative depending on which of the 2 counterparties bear a larger portion of the
exposure and credit quality


CVA impacts P&L even when there is no counterparty default


Accurate pricing of credit risk is important to provide proper incentive to traders


During the Credit Crisis (2007-2009) mark-to-market losses were larger than default losses


CVA losses were much larger than actual losses from counterparty default


Roughly two-thirds of counterparty losses were due to CVA losses and only a third were due to actual
defaults (BCBS Dec 2009)
Counterparty A
Rating: 

AA‐
Avg. CDS Spread:  130 bp
Avg. Exposure:  $11 MM
Pay Fixed
Pay Floating
Counterparty B
Rating: 

BB
Avg. CDS Spread:  245 bp
Avg. Exposure:  $4.0 MM
10-Year USD Interest Rate Swap
® Dante Lomibao – May 2011 31
Calculating Unilateral CVA
CVA

=  EL
1

+ EL
2

+ … + EL
N
EL
k

=  EPE
k

× APD
k

×

LGD
k

×

DF
k
EPE

=  Expected Positive Exposure
PD

=  Cumulative Probability of Default*
APD

= PD(t
i+1

) – PD(t
i

)
LGD

=  Loss Given Default = 1 –

Recovery Rate
DF

=  Discount Factor
*PD is bootstrapped from the credit spread 

using the valuation formula for credit default 

swap. 
This is the PD of the counterparty as seen by 

the Bank and implied by the credit spread of 

the counterparty.
EL
2
EL
3
EL
4
EL
5
EL
1
0
5
10
15
20
25
30
35
0.0 1.0 2.0 3.0 4.0 5.0
Time Horizon (Years)
E
x
p
o
s
u
r
e
 
(
$
M
M
)
Expected Positive Exposure
PE95
Time 
Horizon
Avg. EPE
Cumulative 
PD
Marginal PD
Discount 
Factor
EL
0 0 0.0% 0.00% 1.0000 0
1 2,871 1.0% 1.03% 0.9608 17
2 9,383 3.2% 2.15% 0.9231 112
3 12,403 5.8% 2.65% 0.8869 175
4 10,495 8.4% 2.60% 0.8521 140
5 6,613 10.9% 2.50% 0.8187 81
CVA 525
® Dante Lomibao – May 2011 32
Calculating Bilateral CVA


To calculate CVA, we make two adjustments


Use current market-based implied volatilities and correlations to generate exposures (risk-neutral
parameters)


Use current single-name credit spreads (if available) instead of historical default rates


Bilateral CVA considers the credit quality of both counterparties as well as the exposure of
one vs. the other


If every dealer demanded to be compensated for the risk they take without regard to the risk that their
counterparty is taking, liquidity in the interbank market would dry very fast


Calculate market value of credit risk for both sides


Calculate unilateral CVA of Counterparty A: CVA(A)


Calculate unilateral CVA of Counterparty B: CVA(B)


Counterparty A’s Net CVA = CVA(A) – CVA(B)
Counterparty A
Rating: 

AA‐
Avg. CDS Spread:  130 bp
Avg. Expected Exposure: $11 MM
CVA:  $2.7 MM
Pay Fixed
Pay Floating
Counterparty B
Rating: 

BB
Avg. CDS Spread:  245 bp
Avg. Expected Exposure: $4.0 MM
CVA:  $0.5 MM
10-Year USD Interest Rate Swap
Counterparty A’s Net CVA = $2.7MM ‐

$0.5MM = $2.2MM
CVA(A) = $11MM ×

245bp ×

10 years = $2.7MM
Counterparty B’s Net CVA = $0.5 ‐

$2.7MM = ‐$2.2MM
CVA(B) = $4MM ×

130bp ×

10 years = $0.5MM
Credit Risk Capital
® Dante Lomibao – May 2011 34
What is Credit Risk Capital?


Credit Risk Capital – Amount of money that a Firm needs to set aside to cover
unexpected losses due to borrower or counterparty default
VaR
o
EL
UL
CVaR
o
Expected Loss
(Average credit loss)
Unexpected Loss
(std. deviation of the loss distribution)
Credit Value-at-Risk
(Confidence level loss)
Conditional Value-at-Risk
(Avg. Tail Loss)


Capital Requirement – Bank regulations set a framework under the Basel Accord on
how banks and other depository institutions should calculate and handle heir capital
requirements.
® Dante Lomibao – May 2011 35
The Basel Accord


A set of agreements set by the Basel Committee on Bank Supervision (BCBS)


Provides recommendations on banking regulations in regards to credit risk, market risk and operational
risk.


The purpose of the accord is to ensure that financial institutions have enough capital on account to
meet obligations and absorb unexpected losses


The Accord uses the “three pillars” concept


Pillar 1: Minimum Capital Requirements (addressing credit, operational and market risks)


Pillar 2: Supervisory Review (deals with all other risks a bank may face)


Pillar 3: Market Discipline– to promote greater stability in the financial system


Under Pillar 1, Credit Risk can be calculated using one of three approaches:


Standardized Approach
-

Uses standard risk weights (e.g., 0% for short term govt. bonds, 20% for OECD banks, etc.)


Foundation IRB (Internal Ratings-Based) Approach
-

Banks are allowed to develop their own PD model but can use only regulator prescribed LGD and
other parameters required for calculating Risk-Weighted Assets (RWA)


Advanced IRB Approach
-

Banks are allowed to develop their own empirical models to estimate Probability of Default (PD),
Exposure at Default (EAD), Loss Given Default (LGD), and other parameters used in calculating
RWA
® Dante Lomibao – May 2011 36
Calculating Regulatory Capital


Regulatory Credit Capital under Basel II is equal to 8% of the Risk-Weighted Asset (RWA)


RWA – Bank’s asset weighted according to its credit risk
-

Example, loans secured by a letter of credit would have higher risk-weight than a mortgage loan that is
secured with collateral or government securities have less risk-weight than corporate bonds


Risk-Weighted Asset (RWA) = Credit Risk Weight ×

Exposure at Default = CRW ×

EAD


CRW is the weight assigned to Bank’s particular asset


EAD (Exposure at Default) is the time-weighted average of the Expected Positive Exposure (EPE) Profile
times a multiplier equal to 1.4


Credit Risk Weight


CRW is function of
-

Probability of Default (PD)
-

Loss Given Default (LGD)
-

Maturity of the Exposure (M)


Additional parameters R and “b” are functions of PD


CRW is based on a single-factor model where the default of a counterparty depends on the return of
the counterparty’s assets


Single-factor is a stylized state-of-the-economy, and whereby the assets of the counterparty have a correlation equal
to R
( ) ( ) ( )
| |
(
¸
(

¸

× ÷
÷ × +
×
(
(
¸
(

¸

|
|
.
|

\
|
÷
+
× =
÷ ÷
b
M b
R
N R PD N
N LGD CRW
5 . 1 1
5 . 2 1
1
999 . 0
1 1
( ) ( )
2
ln 05898 . 0 08451 . 0 PD b × ÷ =
( )
( )
( )
( )
(
¸
(

¸

÷
÷
÷ × +
÷
÷
× =
÷
× ÷
÷
× ÷
50
50
50
50
1
1
1 24 . 0
1
1
12 . 0
e
e
e
e
R
PD PD

Outline

Fundamental Concepts in Credit Risk Measurement
 What is Credit Risk?  Components of Credit Risk  Market Risk vs. Credit Risk

Counterparty Exposure Measurement
 Evolution of Counterparty Exposure Measurement Techniques  The Nature of Counterparty Credit Risk  Potential Future Exposure (PFE) Probability Distribution  How PFE Evolves Over Time  Traditional Approaches in Mitigating Counterparty Credit Risk

Credit Valuation Adjustment (CVA)
 What is CVA  Calculating Unilateral CVA  Calculating Bilateral CVA

Credit Risk Capital
 What is Credit Risk Capital  Basel II Capital

® Dante Lomibao – May 2011

2

Fundamental Concepts in Credit Risk Measurement

What is Credit Risk?  What is Credit Risk?  Credit Risk represents the volatility (uncertainty) of losses due to credit events such as default or rating downgrades  Types of Credit Risks  Lending Risk  Borrower Defaults Loan value decreases because of  Decrease in credit quality of borrower  Increase in general credit spread Issuer of security defaults Security’s market value decreases because of  Decrease in credit quality of borrower  Increase in general credit spread Counterparty defaults  In an exchange. we pay but do not receive (Settlement Risk)  Counterparty defaults before settlement and contract has positive value to us Market value of counterparty risk has increased because of  Increase in the credit spread of the counterparty relatively to us  Increase in counterparty exposure relative to its exposure to us  Issuer Risk   Counterparty Risk  ® Dante Lomibao – May 2011 4 .

0  di  0. t  1   i  t   B  0.Components of Credit Risk  Exposure  Amount that we can lose as a result of counterparty or borrower default  Exposure is dynamic for market-traded instruments  Credit Worthiness  Probability of Default – the likelihood that a borrower/counterparty will default  Credit Rating Migration – Potential loss may occur when a borrower/counterparty migrates to a lower rating as PV of positions are discounted at higher risky rates  Loss Severity (Loss Given Default)  In the event of default. t      n Joint Distribution = Loss Distribution Exposure Distribution Default Distribution Recovery Distribution ® Dante Lomibao – May 2011 5 . the amount that we are likely to lose  LGD = 1 – Recovery Rate Credit Loss Distribution L p  t    i 1 max  X i  t  .

Credit Exposure  Current Exposure  Current replacement cost (amount that we can lose if the counterparty defaulted today)  For loan products.  Settlement risk comprises both credit and liquidity risks.  Happens when one party defaults on its clearing obligations to one or more counterparties. ® Dante Lomibao – May 2011 6 . this is the loan principal plus accrued interest rates  For traded products. this is the current mark-to-market of the counterparty’s portfolio  Potential Future Exposure Estimate of future replacement cost (amount that we can lose if the counterparty defaulted at some time in the future)  Worst Case Exposure (Confidence Level Exposure) The maximum amount that we can lose as a result of counterparty default at a given time and confidence level  Peak Exposure The largest worst-case exposure across time up to he maturity of the longest contract in the counterparty’s portfolio  Expected Exposure Average amount that we can lose at a given time as a result of counterparty default  Settlement Exposure Risk that a settlement in a transfer system does not take place as expected.

Credit Risk  Market Exposure  Potential loss in market value of position if market risk factor goes against our position.  Example: Assume we bought a MSFT call option on 100 shares from counterparty ABC at $26 strike. assuming no recovery from counterparty ABC Attribute Market Risk  Credit Risk  Time Horizon  Short-Term risk (1-10 days) Single Step Adverse Market Move ~ Normal (Usually approximated as normal) Matching Positions Risk can be eliminated by offsetting positions Realization not dependent on legal issues    Long-Term Risk (Up to the longest tenor in a counterparty’s portfolio since peak exposure may occur several years into the future) Multi-Step Loss is contingent on counterparty defaulting when we have trading gains Large Negative Skew Arises from significant (although small) probability of a large loss Use of Netting Agreements Collateral Groups Mutual Terminations Obligor Diversification Magnitude of risk is affected by enforceability of netting agreements Nature of Loss Distribution     Risk Mitigation    Legal Issues   ® Dante Lomibao – May 2011 7 .  Example: If we are net long 100 shares of MSFT at $26 and the price goes to $20 a share. If MSFT moves to $30 a share and the counterparty defaults. then we have a market loss of $600  Credit Exposure  Potential loss if our aggregated position with a counterparty has a positive PV and the counterparty defaults.Market Risk vs. we can potentially lose $400.

18% Bond Price 110.1 Bond Price ($) Recovery Rate ® Dante Lomibao – May 2011 8 .33% 10 5.8 85.30% 200 1.7 96.9 106. Credit Risk Distribution of prices of a 10-yr BBB rated corporate bond (Semi-Annual Coupon of 7.2 44.Market Risk vs.93% 50 5.5%) 35 30 Probability (%) 25 20 15 10 5 0 40 Actual Normal Approximation 50 60 70 80 90 100 110 120 130 Bond Price ($) Distribution of prices of a 10-yr BBB rated corporate bond driven by credit events 40 35 BBB Actual Probability (%) 30 25 20 15 10 5 0 40 50 60 70 80 90 100 110 120 130 Normal Approximation Rating AAA AA A BBB BB B CCC D Default CCC B BB A AA AAA Transition  Spread (bp) Prob 0.02% 5 0.4 60.17% 400 0.0 109.12% 1.000 0.6 108.95% 20 86.

80 2.02 0.06 0.00 0.61 53.61 14.08 0.66 3.02 0.00 0.68 91.11 0.21 AAA AA A BBB BB B CCC/C Average Annual Transition Probabilities (2008-2009) AAA 88.36 14.61 0.04 0.43 23.18 0.01 0.74 1.03 5.76 91.08 51.03 5.19 Default Rate (%) 80 70 60 50 BB A AAA AA A BBB BB B CCC/C Investment Grade Speculative Grade All Rated 0.93 27.93 CCC/C 1.00 0.43 22.38 17.64 90.55 3.24 1.68 52.96 82.51 0.00 BB 0.83 7.24 0.77 14.07 51.17 25 3.97 42.26 0.10 11.50 91.00 0.32 10 0.46 0.64 42.04 9.67 43.02 BBB 40 30 20 10 0 0 5 10 15 20 25 B CCC/C AA Years  Historical Default Rates 5.73 70.44 73.18 0.23 0.20 0.00 0.73 3.00 0.36 1.33 CCC/C 0.58 10.08 0.00 66.08 4.55 5.29 21.87 9.06 0.00 BBB 0.01 6.33 0.64 6.23 0.48 0.00 0.03 0.23 44.03 0.33 BB 0.00 AA 8.07 0.08 0.78 0.71 40.0% 4.84 17.00 0.60 0.27 4.35 9.00 0.12 4.00 0.34 3 0.48 6.96 0.0% 1.0% 3.50 0.56 5.99 55.21 0.21 0.74 10.96 D 0.83 18.26 84.40 15 1.40 4.28 48.14 0.09 0.18 11.33 90.99 8.36 2.16 0.90 0.22 BBB 0.02 0.56 8.0% 2.07 6.23 0.00 0.69 8.88 9.06 20 1.11 Initial Rating  AA A BBB BB B CCC/C Cumulative Default Rates Years 1 2 0.00 AA 7.15 31.99 B 0.36 81.00 0.04 0.0% 0.20 1.73 2.90 61.06 83.89 0.23 41.66 1.76 3.16 2.26 0.04 7.00 A 1.00 0.00 0.95 18.06 0.02 0.22 0.47 0.86 8.92 2.03 66.12 0.00 A 0.23 20.46 49.16 0.67 5.00 0.27 0.83 5.00 B 0.36 3.Probability of Default and Credit Migration  S&P One-Year Transition Matrix Average Annual Transition Probabilities (1981-2010) AAA AAA 90.45 3.16 73.00 0.0% Credit Downturns Default Rate 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 ® Dante Lomibao – May 2011 9 .02 0.11 0.13 0.63 30.13 15.05 0.93 56.21 5 0.06 0.47 4.15 31.00 0.86 0.05 0.27 5.94 0.06 0.99 79.03 34.54 1.08 0.30 10.58 4.33 7.31 0.34 0.17 0.05 6.09 18.24 1.88 4 0.92 D 0.

Counterparty Exposure Measurement .

the replacement value of the swap increases Bank’s exposure to Corporation A  Counterparty A defaults. LIBOR goes up and the swap has positive MTM to the Bank  Since the Bank receives Libor + Spread (pays Fixed).The Nature of Counterparty Credit Risk Counterparty risks…    are by-product of privately-negotiated derivatives transactions create a chain of dependencies among derivatives counterparties lead to exposures that must be measured and managed Swap Rate1 Swap Rate2 Corp A Libor + Spread1 Bank Libor + Spread2 Corp B Default!!!! Bank’s exposure to Corporation B  Counterparty B defaults. LIBOR goes down and the swap has positive MTM to the Bank  Since the Bank receives a fixed rate (pays Libor + Spread). the replacement value of the swap increases ® Dante Lomibao – May 2011 11 .

The Nature of Counterparty Credit Risk Cash Flows in the Event of Default Swap Rate Bank Libor + S Corp B PVrisk-free  0 (Bank’s PV) PV) PVrisk-free  0 (Bank’s Bank Receives   PVrisk-free Bank’s Loss = (1 – )  PVrisk-free Corp B defaults PVrisk-free  0 (Bank’s PV) PV) PVrisk-free  0 (Bank’s Bank Pays PVrisk-free Bank’s Loss = 0 Bank’s Loss on Default = (1 – )  max(0. PVrisk-free)    1 the Recovery Rate Expected Loss: EL(swap) = PVrisk-free(swap) – PVrisky(swap) To compensate for EL: PVrisk-free(swap+ S) = PVrisky(swap) ® Dante Lomibao – May 2011 12 .

g. there is less uncertainty in the magnitude of future exposure and very close to the notional for bullet loans  Counterparty exposures could only be described statistically  For large dealers. all loans add to the exposure at all times ® Dante Lomibao – May 2011 13 .Difference Between Lending and Counterparty Credit Risk  The market value of a derivative contract (e. either parties can have exposure to the other depending on the future state of the market  The magnitude of counterparty exposure depends on the uncertain future state of the market  For most loans. the exposures from various trades may offset each other at given states of the market  For lending products. swap or forward) with a counterparty could potentially be positive or negative  Unlike loan wherein the Lender has only the exposure to the Borrower  In counterparty risk.

the add-on is still static  Monte-Carlo Simulation  Considers the volatilities and correlations of various risk factors that determine the exposure Monte-Carlo Simulation Dynamic (MTM + Add-On) Static Factor Notional Amount ing eas Incr 1990’s ity plex Com 1980’s 1990’s ® Dante Lomibao – May 2011 14 .Evolution of Exposure Measurement Techniques  Notional Approach – Exposure equals notional amount  Ignores the market value of the positions  Ignores the volatilities and correlations between market factors that determine the exposure  Static Factor – Exposure is equal to Notional x Factor  Constant factor does not change with life of trade nor with the granularity of trade types  Ignores the current mark-to-market of trades  MTM + Add-On – Exposure is equal to MTM plus add-on determined by the notional x factor  Although MTM is dynamic.

the 950th largest exposure ® Dante Lomibao – May 2011 15 . Market factor movements causing negative MTM do not result in credit exposure.).Probability Distribution of Potential Future Exposure Credit exposure is asymmetric with the underlying market factor (rate. • Only outcomes in the shaded area result in exposure • EPE is the average of the non-negative exposures.e. then EPE = Sum{max[0. etc. price. If there are 1.. Potential Future Exposure (at the 1-year simulation point) Portfolio Value MTM (Current Exposure) 95th Percentile Exposure (PE95) Expected Positive Exposure (EPE) Past 5th Percentile Exposure Time today t = 1 yr.Exposure(i)]}/1000 • PE95 is the 95th percentile exposure. i. index.000 simulation paths.

Simulation of Portfolio Potential Future Exposure Simulate Paths of Market Factors. Apply Historical Covariance  6M $ Libor JPY/USD Possible  paths of  6M USD  Libor Possible  paths of  JPY/USD  FX Rate Past Today 2 Yr Past Today 2 Yr Potential Future Exposure PFE ($) 95% Confidence‐Level Possible  paths of  Portfolio PV Past Revalue portfolio using  simulated values of USD  Libor and JPY/USD rates Today 2 Yr ® Dante Lomibao – May 2011 16 .

Counterparty Exposure Profile Credit Limit Worst Case Exposure Expected Exposure Peak Exposure 95% Confidence Level Portfolio Value Time t ® Dante Lomibao – May 2011 17 .

1…V1.622 303 3.646 4.107 4.677 ‐2.055 ‐3.233 1.193 1.1 Expected Positive Exposure Potential Future Exposure (PE95) Trade 1 Receive Fix 1.7 19 20 9.051 ‐959 1.1 4 5 9.087 ‐728 1.4 7 8 11.0)} ® Dante Lomibao – May 2011 95th Percentile Exposure (19th Largest Exposure out of 20) 18 .2 20 Expected Exposure Average 10.555 364 2.339 0 4.000 10 1 Trade 2 ‐1.555 ‐829 2.0) = 0 EPE without Netting  EPE with Netting Average(V1.4 8 9 8.982 ‐656 1.396 Discount Rate 4% Tenor 1 year Bank has two one-year forward trades with a Counterparty: Trade 1 Bank Receives a Fix Price of $11 per barrel of oil and pays floating price for 1000 barrels Trade 2 Bank Receives a Fix Price of $10 per barrel of oil and pays floating price for 2.) Simulated Oil  Scenario # Scenario # Price 1 10.430 1.0)+….339 ‐4.000 11 1 Trade 1 369 1.735 ‐378 ‐392 2.1.215 2.548 ‐2.316 1.+ Max(V1.555 T1 + T2  (With Netting) ‐814 3.646 508 3.6 1 2 9.577 ‐135 750 2.159 364 1.055 Max(-378.723 6.280 252 ‐3.326 1.20.622 ‐1.001 2.7 15 16 9.751 4.159 Trade 2 Receive Fix 2.378 2.751 1.190 ‐225 ‐502 60 ‐1.7 3 4 9.430 1. of Barrels Fixed Price Maturity (Yr.889 3.042 ‐3.282 ‐3.1 2 3 10.848 303 1.0) + Max(-2677.784 1.013 3.6 10 11 9.4 11 12 10.746 623 208 1.7 5 6 8.2 6 7 11.774 ‐1.723 6.282 0 0 4.9 16 17 11.556 848 710 991 321 1.746 848 710 1.0 14 15 10.749 893 1.000 barrels T1 + T2  (W/O Netting) 369 3.023 ‐3.098 4.9 18 19 11.023 0 3.3 13 14 10.20) Sum{Max(V1.326 758 1.706 2.051 321 1.Calculating the Exposure Metrics No.1 12 13 10.8 9 10 10.396 ‐1.8 17 18 8.183 1.555 -378 + -2677 = -3.

5% 0.5% 7.5% 5. there is no “amortization” effect since cash-flow occurs only at maturity date.0% Potential Exposure of an FRA 2. FX Forward).How Potential Future Exposure Evolves Over Time Diffusion and Amortization There are two main factors that determine how the potential future exposure varies with time: diffusion and amortization  Diffusion  As time passes. Rate 6. the “amortization effect” tends to decrease exposure as periodic payments are made reducing the remaining cash-flow that is exposed to default  For single cash-flow products (e.g.5% 0 95% Confidence-Level Interest Rate 2.0% 1 2 3 4 5 0 1 2 3 4 5 Years in Future Years in Future ® Dante Lomibao – May 2011 19 . the “diffusion effect” tends to increase exposure since there is greater potential for rates to move away from current levels  Amortization  As time goes by.5% 1. Diffusion of Interest Rate 7. Exposure is purely due to diffusion.0% 5.0% 4.0% 1.5% Potential Exposure (% of Notional) Potential Int.0% 95% Confidence-Level Potential Future Exposure F lat Yield C urv e = 5% Volatility = 10% 0..5% 6.

50 4.5 4.9 9.5 1.0 4.82 7.5 3.00 2.9 4.1 9.5 8.50 1.7 7.00 0.2 4.01 8.00 Amortization (Remaining Cash Flows) 5 5 5 5 4 4 3 3 2 2 1 1 Potential Future Exposure (% of Notional) 0.65 t 2   5.50 5.1 10.0 1.66 8.5 Time (years) 0.20 9.00 3.25 0.How Potential Future Exposure Evolves Over Time Multiple Cash-Flow Product Projected Rates .0 9.87 6.2 6.0 7.) 4 8% Remaining Cash Flows 0 1 2 3 4 5 3.00 1.6 9.0 3.5 ‐ 0 1 2 3 Years in the Future 4 5 8% 3 6% 6% 2 4% 4% 1 2% 2% ‐ 0 1 2 3 Years in the Future 4 5 0% 0% 0 1 2 3 4 5 Years in the Future Years in the Future ® Dante Lomibao – May 2011 20 .7 5.25 6.5 Example 5-Year Interest Rate Swap Payment Frequency: Yield Curve (Flat): Interest Rate Volatility: Confidence Level: Pay Fix 5% Annual 5% 20% 95% We assume interest rates evolve according to: R(t )  R(0) exp  1  2t  1.0 10.0 4.P.50 3.50 2.64 8.5 2.0 2.27 7.0 7.4 8.3 9.3 6.34 8.3 7.93 9.0 4.95% Confidence (%) 5.00 4.00 5.0 Interest Rate Diffusion 6 Amortization 12% Diffusion x Amortization 12% Potential Exposure 5 Remaining Cash Flows Remaining Cash Flows 10% 10% Interest Rate Change (B.0 0.46 Diffusion (Potential Change in Interest Rate) (In Basis Pts) 0 87 125 182 227 266 301 334 364 393 420 446 Diffusion  Amortization (%) 0.5 4.

000 10-Yr Sw ap 50 Notional Amount = $1 Million 0 0 2 4 6 8 10 0 0 2 4 6 8 10 50.Potential Future Exposure Profiles of Derivative Products Payer Interest Rate Swap 300 Expected Pos i ti ve Expos ure 95% Confi dence PFE 250 250 300 Expected Pos i ti ve Expos ure 95% Confi dence PFE Receiver Interest Rate Swap 250.000 Effect of Maturity Receiver Swap Notional Amount = $1 Million 20-Yr Sw ap Exposure ($'000) Exposure ($'000) 200 200 200.000 Exposure (USD) 150 150 150.000 5-Yr Sw ap Time Horizon Time Horizon - Currency Swap 800 700 600 250 500 400 300 200 100 Expected Pos i ti ve Expos ure 95% Confi dence PFE 350 Interest Rate Cap Expected Pos i ti ve Expos ure 95% Confidence PFE 0 5 10 15 20 Time Bucket (yrs) 300 Exposure ($'000) Notional Amount = $1 Million Exposure ($'000) 200 150 100 50 Notional Amount = $1 Million 0 10 0 2 4 6 8 10 0 0 2 4 6 8 Time Horizon Time Horizon ® Dante Lomibao – May 2011 21 .000 15-Yr Swap 100 100 50 100.

0% 6.0% Interest Rate Evolution – 95% Confidence Interval (30% Volatility) 10.0% 8. the upper confidence band of the interest rate distribution diffuses more than the lower band  This results in a Payer Interest Rate Swap (Bank Pays Fix and Receives Floating Rate) resulting in a larger exposure than a Receiver Interest Rate Swap (Bank Receives Fix and Pays Floating Rate)  In a Payer Swap the Bank has counterparty risk when interest rate goes up since the value of the swap to the Bank increases.0% Upper Interest Rate Band Lower Interest Rate Band Base Rate 6.0% Rup Rup 4.0% 2.Evolution of Interest Rates and Potential Future Exposure Interest Rate Evolution – 95% Confidence Interval (20% Volatility) 10.0% Rdown 0.0% 0 1 2 3 4 5 Time Bucket (Years) 0. The reverse is true for Receiver Swap.0% Rdown 2.0% Interest Rate Level Upper Interest Rate Band Lower Interest Rate Band Base Rate Interest Rate Level 8.0% 4.0% 0 1 2 3 4 5 Time Bucket (Years)  Asymmetry Between the Upper and Lower Confidence Bands  Using a lognormal assumption. ® Dante Lomibao – May 2011 22 .

Possible shapes of 1-yr Forward Rates 6.0% 4.Risk Factor Evolution Single Factor Interest Rate Curve 6.5% R1(z1)= r1 exp[ -0.0% 4. • The random number z determines the direction of the curve.0% 6.5% 1-Yr Rate (%) 5.5% r2 r1 r3 r4 5.5% 1-Yr Rate (%) 5.5% 1-Yr Rate (%) R1(z1) R2(z2) R3(z3) R4(z4) 5.5% 0 1 2 Years 3 4 3.0% 3.0% 5. • When z is positive.5 2 + z 1] • In single-factor model.5% 4.0% R2(-z2) R1(-z1) 0 1 2 Years 3 4 3.5% 0 1 2 Years 3 4 ® Dante Lomibao – May 2011 23 .5% R3(-z3) 4. the whole curve shifts up and shifts down when z is negative.0% 5.0% 4.0% R4(-z4) 4. we use the same random number z for all parts of the curve.

Risk Factor Evolution Single-Factor vs. Multi-Factor Interest Rate Curve Possible Outcomes of the 3-Month Forward Interest Rate Curve (One-Factor) (5 Years into the Future) 10% Possible Outcomes of the 3-Month Forward Interest Rate Curve (Three-Factors) (5 Years into the Future) 10% 8% Forward Rate (%) 8% Forward Rate (%) 6% 6% 4% 4% 2% S1 0% 0 5 10 15 20 25 30 35 S2 S3 S4 S0 2% S1 S4 0% 0 5 10 15 20 25 30 35 S2 S0 S3 Tenor (Years) Tenor (Years) Fk  t   Fk  0  exp    1  2t 2 k  z k t   3 i 1 3 i i i Fk  t   Fk  0  exp  z  t   PCk    t PCk   i  2 i 1  i 1    2     ® Dante Lomibao – May 2011 24 .

5% 0 1 2 Years 3 4 ® Dante Lomibao – May 2011 25 .512 + z11] • The random numbers zi's determine the direction of the curve.0% 5.5% 4.0% 3.5% 4.5% 1-Yr Rate (%) R1(z11) R2(z22) 5.0% 5. • When zi is positive. Possible shapes of 1-yr Forward Rates 6.5% 0 R1(-z11) 1 2 Years 3 4 R1(z11)= r1 exp[-0.5% r2 r1 4.5% 0 1 2 Years 3 4 3. we use different zi's for each part of the curve.0% 1-Yr Rate (%) r3 R3(-z33) r4 5.0% R4(-z44) R2(-z22) 4.0% 3.0% 4. • In multi-factor model. the particular forward rate shifts up and shifts down when zi negative.0% 6.0% 4.5% R3(z33) R4(z44) 5.5% 1-Yr Rate (%) 5.Risk Factor Evolution Multi-Factor Interest Rate Curve 6.

0 8.5 0.0 3.1 1.2 2.0  Credit Enhancements   Collateral Agreements (Credit Support Annex – CSA) Early Termination Agreements (Derivatives contracts are terminated prior to their contractual settlement date.5 -2.6 1.2 7.7 4.3 5.5 2 2.2 1.0 2. Credit Triggers etc.7 1.5 10.2 9.4 5.3 -3.5 9.) Trade 5 Exposure Without Netting With Netting Exposure (w/ Netting) Collateral and Exposure Collateral Account* Exposure (w/ Netting & Collateral) 5.1 1. usually triggered by events of default) Guarantees (Third-Party of Parent Guarantee) Embedded Option to Cancel or Shorten Maturity (Liquidity Puts.0 -0.7 1.5 4 1.6 5 -1.8 8.0 5.0 0.2 8.0 0.0 -2.7 -1.Traditional Approaches in Mitigating Counterparty Credit Risk  Netting    ISDA Master Agreement Allows negative and positive exposure to cancel each other in the event of default Enforceability of the close-out netting provisions is crucial Trade Number Sample Path of Counterparty’s Exposures Time Bucket (Years) 0 Trade 1 Trade 2 Trade 3 Trade 4 -1.5 3.2 -2.2 4.9 1.5 -1.0 0.2 4.3 -2.1 2.0 0.0 2.0 3 3.8 4.5 8.5 9.0 1.3 2.7 9.3 0.5 -1.0 1 -1.2 3.8 1. 12 10 Exposure ($MM) 8 6 4 2 0 ‐2 0 1 2 3 Time Bucket (Years) 4 5 Exposure (w/ Netting & Collateral) Exposure (w/ Netting) Without Netting  Exposure Limits   Confidence-Level Potential Exposure Limit (PE95) or Net Current Exposure Limit Usually dependent on the credit quality of the counterparty ® Dante Lomibao – May 2011 26 .0 1.2 5.0 0.8   * Positive number means that we hold the collateral and negative means that we provide collateral to counterparty.0 -0.

Impact of Collateral on Exposure DAY 0 MTM1 Exposure  without  Collateral DAY 0 to Day 5 Exposure without Collateral MTM0 Collateral C0 Unsecured  Threshold Margin Call Lag C0 Minimum Transfer  Amount Exposure with  Collateral Exposure with Collateral DAY 5 MTM1 MTM0 C1 C0 Exposure (USD) Exposure  without  Collateral Time Profile with Collateral 30 25 20 15 10 5 - Collateral C0 Unsecured  Threshold Margin Call Lag Minimum Transfer  Amount Exposure with  Collateral Days 0 5 10 15 20 25 30 35 Exp. w/o Coll Exp. w/ Coll Threshold ® Dante Lomibao – May 2011 27 .

0 05 00 0 0 1 0 2 0 0 0 0 5 .0 4.0 0 0 .00 0 0505 0.0 0 .0 5 0 0 4 .000 0 00 12 10 0 0 0 .84 30.27 26.18 23.0 0 0 0 0 0 5 0.42 22.00 0 2 .0 0 .88 66.0 3.70 22.0 0 00 .5 5.5 4.0 0.Stress .42 14.27 25.) 0.00 0 0 1 0 0 0 0 87 .03 25.18 23.56 30.0 05 5 0 0.00 0 1 .0 .03 24.00 .05 22.0 0 0 0 5 .0 0.00 .00 0 0 .00 .00 0 2 .0R.0 .0 0 .00 0 2 .Limit Monitoring .0 4.49 Correlated Market Scenarios Simulated Market Scenario (Interest Rates.0 O 2 .63 25.0 0 0 0 .0 0 01 0 .0 1 .0 0 .07 25.Economic Capital .0 0 0 0 .0 5.0 0 0 2 .89 25.85 40.0 0 0.09 25.18 23.0 0 0 5 .88 31.18 23.5 5.00 0 3 1 0.49 31.0 2.18 23.66 26.Other Credit Mitigations Analytic Tools .0 5 .18 23.18 22.18 23.0 0 Exposure Distributions Aggregation .0 0 417 7 .0 .30 21.18 23.09 25.18 Trade Data Prd D Id Inst D eal esc T rade D ate Prd D eal Fixed/Float w esc T ct-2002 rade ate CO M 21846 Id Inst D S ap 2-O D Prd D Id Inst D S ap eal Fixed/Float w esc T ct-2002 rade D CO 21846 2-O ate CO M 21949 Fixed/Float S ap M w 7-O ct-2002 CO 21846 Fixed/Float S ap CO M 21949 Fixed/Float ap w 4-O 2-O 7-O ct-2002 ct-2002 CO M 21956 Fixed/Float S S ap M ww ct-2002 CO 21949 Fixed/Float w CO M 21958 Fixed/Float S S S ap 4-O 7-O M 21956 Fixed/Float apap w 4-O ct-2002 ct-2002 CO M w ct-2002 CO 21956 Fixed/Float w CO M 23222 Fixed/Float S S S ap 25-O 4-O M 21958 Fixed/Float apap w 4-O ct-2002 ct-2002 CO M w ct-2002 CO 21958 4-O CO M 23222 ap Fixed/Float S ap 25-O ct-2002 ww CO M 23224 C Fixed/Float S ap 25-O ct-2002 M ct-2002 CO 23222 Fixed/Float S ap 25-O ct-2002 w 25-O CO M 23224 Cap CO M 23225 Floor M 25-O ct-2002 ct-2002 CO 23224 Cap 25-O CO M 23225 erm 25-O ct-2002 CO M 23226 B Floor S aption 25-O ct-2002 M udan w ct-2002 CO 23225 erm Floor w 25-O CO M 23226 Ber udanS aption 25-O ct-2002 CO M 23233 Pow Financial S ap 25-O ct-2002 M w ct-2002 CO 23226 Ber udanS aption 25-O erm ww CO M 23233 Pow Financial S ap 25-O ct-2002 M ct-2002 CO M 23233 Pow Financial S ap 25-O er w ct-2002 Simulated PV’s Valuation .18 23.18 23.0 .0 0 2 66 2 .09 SGD SGD 66.00 0 00 1 0.0T 0 P0T A0H0S 0 D PT 0E H D A 0 0 R O R O 3 54 6 2 0.18 23.Counterparty Exposure Calculation Process Market Data / Parameter Calibration Years HKD Years HKD 0.30 27.Credit Lines and Availability .Notional Factors Netting.0 4.0 0 0 3 71 0 5 0 0 00 5 00 0 0 2 .0 0 0 .0 .08 TWD TWD 14.38 19.61 21.0 4 7 2 51 .00 0 11 .91 26.0 0 0 .92 22.0 1 53 7 1 0 .00 .0 .00 .09 25.00 0 2 66 2 .0010.0 0 5 0 0 .0 0 0 .05 28.5 3.0 1 0 0 .0 0 5 3 0 0 0 0 02 00 0 0 0 0 .05 .0 .68 25.0 0 1 0 .00 0 68 .56 30.0 0 0.0 3.27 25.0 0 0 0 5 .0 0 0.0 0 1 0 0 .5 3. Collateral.0 0.96 40.18 23.70 22.0Years 32.0 .5 5.0 05 0 0 0 0 1 0 2 0 0 00 5 .P&L Grids .5 2.00 0 5 0. etc.00 .07 25.09 25.0 5.0 0 0 .0 .00 .05 21.0 0 0 0 0 0.18 12.89 25.59 26.18 23.09 25.88 31.00 .97 24.0 0 0 4 74 8 1 0 5 0.00 0 87 0 5 0.09 25.05 .0 1 5 7 . Referential Data C D# B MA C MA B T RS OD C T RS OD S A T P T A HEH L P HEH L 1 5 S # 1 B0M0 5C MA B5T 0E H L C 0H0S 0L 4C D .00 .5 33.13 23.0 4 .97 24. Credit Spreads.5 33.38 19.0 0 5 0 0 .09 25.66 25.30 21.05 21.38 KRW 12.00 0 652 9 .Collateralized .01 .0 . Commodities.68 22.18 23.5 1.0 0 6 52 9 0.00 0.97 19.42 23.18 23.CVA .05 .92 TWD 14.5 33.09 25.0 0 0 2 .13 23.18 23.00 .0 0 0.05 .0 0 .00 0 .0 0 .30 21.5 2.0 0 0 5 2 .5 5.0 0 0 0 0 4 7 4 8 51 . FX Rates.08 21.0 2.59 26.0 65 .63 25.0 1.Regulatory Capital ® Dante Lomibao – May 2011 28 .18 23.92 22.0 0 .18 23.0 3.00 0 1 .05 29.0A.18 27.67 29.09 25.42 24.0 0 0 00 01 0.0 0 0 0 .18 22.42 24.03 25.30 29.0 O 0 0 C D# 1 B0M0 5C MA B5T 0E H L C 0H0S 0L S A.85 40.00 .42 23.00 0 46 .08 21.18 23.05 28.0 2.48 32.18 23.91 26.00 .00 .49 31.89 24.0 0 0 5 0.68 22.96 27.18 23.5 4.0T 0P0T A0H0S 0 D PT 0E H D 6 7 0 0A 0 0 .0 0.0 0 0 2 .18 23.0 0 7 0 0 .5 4.05 .84 29.0 0 0 .09 25.00 0 02 00 0 0 7 .000 0.67 31.48 HKD 0.30 27.0 157 26 1 0 .0R.0 0 1 53 7 1 0 5 0.07 25.96 27.5 2.00 0 0 .0 0 5 0 0.0 0 0 5 74 6 439 7 52 .00 0 5 0 0 0 0 3 1 0.0 0 0 50 0 0 0 0 0 00 0 00 12 1 0 5 0 0 0 0 5 0 0 0 0 2 .5 3.00 20.00 0 85 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 00 0 00 00 00 00 357 46 2 0 .0 0 0 0 0 0 .00 0 61 2 2 0 .0 1.85 SGD 66.00 0 0 1 .70 23.63 31.0 0.56 32.00 0 .0 .66 KRW KRW 12.0 1.0 0.0 0 0 0 0 .5 1.48 1.0 4 .61 22.59 28.18 23.84 29.Full Revaluation .18 23.18 23.91 27.0 .61 21.09 25.67 29.13 22.0 0 0 0 0 0 0 .Taylor Expansion .

Pricing Counterparty Risk The Credit Valuation Adjustment (CVA) .

 CDS Spread:  130 bp Avg. CDS Spread:  245 bp Avg. Exposure:  $11 MM 10-Year USD Interest Rate Swap Counterparty B Rating:  BB Avg.What is Credit Valuation Adjustment (CVA)?  CVA is the market value of the credit risk due to counterparty default   It is equal to the Net Present Value of expected future credit losses due to counterparty default CVA = PV { (Expected Positive Exposure)  (Credit Spread) }  CVA is sensitive to both the exposure and the 2 counterparties credit spreads  Adjustment can be positive or negative depending on which of the 2 counterparties bear a larger portion of the exposure and credit quality Pay Fixed Counterparty A Rating:  AA‐ Avg.0 MM Pay Floating    CVA impacts P&L even when there is no counterparty default Accurate pricing of credit risk is important to provide proper incentive to traders During the Credit Crisis (2007-2009) mark-to-market losses were larger than default losses  CVA losses were much larger than actual losses from counterparty default  Roughly two-thirds of counterparty losses were due to CVA losses and only a third were due to actual defaults (BCBS Dec 2009) ® Dante Lomibao – May 2011 30 . Exposure:  $4.

871 9.613 EL 0 17 112 175 140 81 525 ® Dante Lomibao – May 2011 31 .0% 0.9% 2.0 *PD is bootstrapped from the credit spread  using the valuation formula for credit default  swap.50% Discount  Factor 1. EPE 0 2.60% 10.4% 2.8521 0.Calculating Unilateral CVA 35 Expected Positive Exposure 30 PE95 CVA =  EL1 + EL2 + … + ELN ELk EPE PD PD LGD DF =  EPEk  PDk  LGDk  DFk =  Expected Positive Exposure =  Cumulative Probability of Default* = PD(ti+1) – PD(ti) =  Loss Given Default = 1 – Recovery Rate =  Discount Factor 25 Exposure ($MM) 20 15 10 5 EL1 0 0.8% 2.2% 2.8187 CVA Avg.  This is the PD of the counterparty as seen by  the Bank and implied by the credit spread of  the counterparty.65% 8.495 6.0 EL2 2.9608 0. Time Horizon (Years) Time  Horizon 0 1 2 3 4 5 Cumulative  Marginal PD PD 0.15% 5.0% 1.403 10.8869 0.0 1.0 EL4 4.03% 3.9231 0.0 EL3 3.0 EL5 5.383 12.0000 0.00% 1.

the other  If every dealer demanded to be compensated for the risk they take without regard to the risk that their counterparty is taking. we make two adjustments  Use current market-based implied volatilities and correlations to generate exposures (risk-neutral parameters)  Use current single-name credit spreads (if available) instead of historical default rates  Bilateral CVA considers the credit quality of both counterparties as well as the exposure of one vs.5MM = $2. CDS Spread:  130 bp Avg. Expected Exposure: $11 MM CVA:  $2.5 MM Pay Floating Counterparty A’s Net CVA = $2.0 MM CVA:  $0.2MM CVA(A) = $11MM  245bp  10 years = $2.2MM CVA(B) = $4MM  130bp  10 years = $0.5MM ® Dante Lomibao – May 2011 32 .7 MM Pay Fixed 10-Year USD Interest Rate Swap Counterparty B Rating:  BB Avg. Expected Exposure: $4.Calculating Bilateral CVA  To calculate CVA.5 ‐ $2. CDS Spread:  245 bp Avg.7MM = ‐$2.7MM Counterparty B’s Net CVA = $0. liquidity in the interbank market would dry very fast  Calculate market value of credit risk for both sides  Calculate unilateral CVA of Counterparty A: CVA(A)  Calculate unilateral CVA of Counterparty B: CVA(B)  Counterparty A’s Net CVA = CVA(A) – CVA(B) Counterparty A Rating:  AA‐ Avg.7MM ‐ $0.

Credit Risk Capital .

Tail Loss) Credit Value-at-Risk (Confidence level loss)  Capital Requirement – Bank regulations set a framework under the Basel Accord on how banks and other depository institutions should calculate and handle heir capital requirements. deviation of the loss distribution) UL CVaR VaR Conditional Value-at-Risk (Avg.What is Credit Risk Capital?  Credit Risk Capital – Amount of money that a Firm needs to set aside to cover unexpected losses due to borrower or counterparty default Expected Loss (Average credit loss) EL Unexpected Loss (std. ® Dante Lomibao – May 2011 34 .

0% for short term govt.The Basel Accord  A set of agreements set by the Basel Committee on Bank Supervision (BCBS)  Provides recommendations on banking regulations in regards to credit risk. Loss Given Default (LGD).  The purpose of the accord is to ensure that financial institutions have enough capital on account to meet obligations and absorb unexpected losses  The Accord uses the “three pillars” concept  Pillar 1: Minimum Capital Requirements (addressing credit. bonds. etc. Credit Risk can be calculated using one of three approaches:  Standardized Approach   Uses standard risk weights (e. and other parameters used in calculating RWA  Foundation IRB (Internal Ratings-Based) Approach  Advanced IRB Approach  ® Dante Lomibao – May 2011 35 .) Banks are allowed to develop their own PD model but can use only regulator prescribed LGD and other parameters required for calculating Risk-Weighted Assets (RWA) Banks are allowed to develop their own empirical models to estimate Probability of Default (PD). market risk and operational risk.. Exposure at Default (EAD).g. 20% for OECD banks. operational and market risks)  Pillar 2: Supervisory Review (deals with all other risks a bank may face)  Pillar 3: Market Discipline– to promote greater stability in the financial system  Under Pillar 1.

5    CRW  LGD   N     1 R     1  1. loans secured by a letter of credit would have higher risk-weight than a mortgage loan that is secured with collateral or government securities have less risk-weight than corporate bonds  Risk-Weighted Asset (RWA) = Credit Risk Weight  Exposure at Default = CRW  EAD  CRW is the weight assigned to Bank’s particular asset  EAD (Exposure at Default) is the time-weighted average of the Expected Positive Exposure (EPE) Profile times a multiplier equal to 1.08451  0. and whereby the assets of the counterparty have a correlation equal to R ® Dante Lomibao – May 2011 36 .5  b     Credit Risk Weight  CRW is function of    Probability of Default (PD) Loss Given Default (LGD) Maturity of the Exposure (M) 1  e   0.4   N 1 PD   R N 1 0.24  1  1  e  R  0.05898  ln PD  2  CRW is based on a single-factor model where the default of a counterparty depends on the return of the counterparty’s assets  Single-factor is a stylized state-of-the-economy.12   1  e  1  e     50 PD 50 50 PD 50  Additional parameters R and “b” are functions of PD b  0.999   1  b  M  2.Calculating Regulatory Capital  Regulatory Credit Capital under Basel II is equal to 8% of the Risk-Weighted Asset (RWA)  RWA – Bank’s asset weighted according to its credit risk  Example.

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