LO 32.2: Explain the treatment o f counterparty credit risk (CCR) both as a credit

LO 32.2: Explain the treatment o f counterparty credit risk (CCR) both as a credit risk and as a market risk and describe its implications for trading activities and risk management for a financial institution.
The treatment of CCR as a market risk was historically done through pricing in a credit valuation adjustment (CVA). CVA represents the market value of the CCR. Before the 20072009 financial crisis, institutions saw stable credit spreads and CVAs that made up only a small component of a derivatives portfolio. When the financial crisis resulted in unusual losses and gains, institutions began to pay closer attention to risk managing the CVA.
Financial institutions may view CCR as either a credit risk or a market risk and may manage the credit portfolio accordingly, but looking at it as only one type of risk (in a silo) exposes the institution to the risk from the other side.
Treating CCR as a credit risk exposes the institution to changes in CVA; therefore, CVA must be included when valuing a derivatives portfolio. Not including the CVA could lead to large swings in market value. Credit risk is managed at inception or typically through collateral arrangements, but it is not actively managed once the trades are set up. Since at default all trades need to be replaced in the market, emphasis is on risk mitigation and credit evaluation.
Treating CCR as a market risk allows an institution to hedge market risk losses but leaves it exposed to declines in counterparty creditworthiness and default. However, CCR can be hedged through replacing contracts with a counterparty instead of waiting for default to occur. This can be achieved by buying positions in proportion to the counterpartys probability of default (PD). A counterparty with a low PD will only have a small component of its trades replaced this way, while counterparties with deteriorating credit quality will see their trades replaced faster and moved to other counterparties.
The treatment of CCR as both a credit risk and a market risk creates a large variety of measurements that can be complex to interpret. For example, credit risk uses current exposure, peak exposure, and expected exposure, while market risk uses CVA and variability in CVA (measured by VaR of CVA). When stress testing the portfolio, the number of stress
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Topic 32 Cross Reference to GARP Assigned Reading – Siddique and Hasan, Chapter 4
results can be very large. By classifying CCR as both a credit risk and a market risk, the number of stress results would equal at least twice the number of counterparties plus one (stresses are run for each counterparty as well as the aggregate portfolio), and would be at least double that amount again if instantaneous shocks were considered in addition to stressed risk measures.
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