Models and Methods for Counterparty Credit Risk Measurement

Abstract

The last two decades have been characterized by several financial disasters, large institutions collapsed proving that an insufficiency of financial risk management can cause huge losses and ripple effects throughout the financial markets. Quantitative approaches to risk management gained popularity and have been widely adopted. Nowadays firms need to understand their ability to face risks and to manage them carefully. Above all, the financial markets turmoil highlighted the importance of counterparty credit risk which is one of the many complex areas of financial risk. The aim of this research is therefore the understanding, quantifying and being in control of counterparty credit risk. Counterparty risk entails different risk types and is interrelated and sensitive to systemic risk. For this reason, the first chapter sets the scene and describes counterparty risk contextualizing the phenomena within the framework of other financial risks (market, liquidity, operational, credit) introducing fundamental concepts and terminologies such as VaR, expected exposure, mark to market and product coverages. The following two chapters are dedicated to the quantification of credit exposure and the related methodologies, systems and regulators requirements. Going deeply in the analysis it is showed that counterparty credit risk involves derivatives which if on the one hand fostered global financial markets, on the other have been disruptive causing massive losses. Specifically, the last part of the research investigates Credit Default Swaps and studies the influence of counterparty credit risk in the pricing of those fairly complex products. It is finally provided an empirical analysis that applies the discussed quantification methodologies to the reality.