LO 32.8: Describe the common pitfalls in stress testing CCR.

LO 32.8: Describe the common pitfalls in stress testing CCR.
Stress testing CCR includes the following pitfalls:

Stress testing CCR is a relatively new method, and institutions typically do not aggregate CCR with loan portfolio or trading position stress tests. Institutions typically stress test current exposure when incorporating the losses with loan or trading position. This is a mistake, because institutions should instead use expected exposure or positive expected exposure.
Using current exposure can lead to significant errors, which is particularly evident in
at-the-money exposures when measuring derivatives market values.
When calculating changes in exposures, using delta sensitivities is also challenging for
CCR since delta is nonlinear. The linearization of delta sensitivities in models can lead to significant errors.
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Topic 32 Cross Reference to GARP Assigned Reading – Siddique and Hasan, Chapter 4
K e y C o n c e p t s
LO 32.1
The four definitions of counterparty credit risk (CCR) exposure measures are:
Current exposure, or replacement cost, is the greater of zero or the market value of a

transaction (or transactions) upon counterparty default, assuming no recovery in value. Peak exposure measures the distribution of exposures at a high percentile (93% or 99%) at a given future date before the maturity of the longest maturity exposure in the netting group. Expected exposure measures the mean distribution of exposures at a given future date prior to the maturity of the longest maturity exposure in the netting group. Expected positive exposure (EPE) is the weighted average of expected exposures over time, where the weights represent the proportion of individual expected exposures of the entire time interval.
LO 32.2
Credit valuation adjustment (CVA) represents the market value of the CCR. Financial institutions could view CCR as either credit risk or market risk, although it should consider both risks.
Treating CCR as credit risk exposes an institution to changes in CVA. CVA should, therefore, be included in valuing a derivatives portfolio, otherwise the portfolio could experience large changes in market value.
Treating CCR as market risk allows an institution to hedge market risk losses; however, it leaves the institution exposed to declines in counterparty creditworthiness and default.
Treating CCR as both credit risk and market risk is prudent, but this approach is complex and difficult to interpret.
LO 32.3
The most common stress test is stress testing current exposure. Stresses may include equity crash simulations, other credit events, or interest-rate shocks. Counterparties with the largest current exposures are generally reported to senior management.
Stress tests of current exposure have two primary shortcomings. First, aggregating results is challenging and stresses do not factor in the credit quality of the counterparty. Second, they do not provide information on wrong-way risk.
LO 32.4
In a loan portfolio, the expected loss (EL) for any one counterparty is a function of the probability of default (PD^, exposure at default (EATX), and loss given default (LGDj). The EL for a portfolio is the sum of the individual exposures.
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Topic 32 Cross Reference to GARP Assigned Reading – Siddique and Hasan, Chapter 4
The stressed expected loss (ELS) is determined by stressing the PD. The stress loss for the loan portfolio is, therefore, the difference between the stressed EL and EL.
In a derivatives portfolio, the EL for any counterparty is a function of PDj, LGDp and expected positive exposure (EPE^ multiplied by an alpha factor (a).
LO 32.3
Currently, institutions typically only consider a counterpartys probability of default (PD) to the institution (i.e., unilateral CVA). A financial institution should instead consider its bilateral CVA, or the possibility that counterparties could default to the institution and the possibility that the institution could default to its counterparties.
LO 32.6
The formula for calculating CVA across all counterparties is a function of the discounted expected exposure, the risk-neutral marginal probability for a counterparty, and the risk- neutral LGD. The formula depends on market variables, including credit spreads, market spreads, and derivatives values. To calculate a stressed CVA (CVAS), an instantaneous shock is applied to these market variables. The stress loss is the difference between CVAS and CVA.
LO 32.7
Financial institutions should incorporate the value of their option to default to a counterparty through the bilateral CVA, also known as the debt value adjustment (DVA).
The BCVA formula differs from the CVA formula in that BCVA incorporates negative expected exposure (NEE) and the probability of the counterpartys survival.
The probability of survival depends on credit default swap spreads, and the losses depend on the institutions own credit spread. The financial institution should consider stress results for the BCVA. Stress losses are calculated by subtracting the value of the current BCVA from the stressed BCVA.
LO 32.8
Shortcomings of stress testing CCR include:
CCR is not aggregated with loan portfolio or trading position stress tests.
Stress testing current exposure is not optimal. Instead, institutions should use expected exposure or positive expected exposure.
Using current exposure can lead to significant errors, especially for at-the-money
exposures, when measuring derivatives market values.
The linearization of delta sensitivities in models can lead to significant errors.
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Topic 32 Cross Reference to GARP Assigned Reading – Siddique and Hasan, Chapter 4
C o n c e p t C h e c k e r s
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4.
3.
Which of the following exposure measures reflects the average distribution of exposures at a specific future date prior to the maturity of the longest maturity transaction within a netting set? A. Peak exposure. B. Current exposure. C. Expected exposure. D. Expected positive exposure.
Is the following statement on the treatment of counterparty credit risk (CCR) correct? Treating CCR as a market risk does not allow an institution to hedge market risk losses, and it exposes the institution to declines in counterparty creditworthiness and default. A. The statement is correct with regard to both hedging market risk losses and
counterparty creditworthiness and default.
B. The statement is incorrect with regard to both hedging market risk losses and
counterparty creditworthiness and default.
C. The statement is correct with regard to hedging market risk losses only. D. The statement is correct with regard to counterparty creditworthiness and
default only.
An analyst notes that stress testing current exposure is problematic because aggregating results is typically not meaningful, although it is easy to account for the credit quality of the counterparty. Are the analysts statements correct? A. The analyst is correct with regard to both aggregating results and credit quality. B. The analyst is correct with regard to aggregating results only. C. The analyst is correct with regard to credit quality only. D. The analyst is incorrect with regard to both aggregating results and credit
quality.
Which of the following statements best reflects the reason why a financial institution does not need to consider aggregating stresses to the expected positive exposure (EPE) with its loan portfolio? A. Loans are not sensitive to market variables. B. Stresses to EPE are not sensitive to market variables. C. The EPE and the loan portfolio are negatively correlated. D. The EPE and the loan portfolio are positively correlated.
Is the following statement on bilateral credit valuation adjustment (BCVA) correct? The formula for BCVA is similar to the formula for CVA, except that the BCVA formula uses expected positive exposure (EPE) and it incorporates the probability of the counterpartys survival. A. The statement is correct with regard to both EPE and probability of survival. B. The statement is correct with regard to EPE only. C. The statement is correct with regard to probability of survival only. D. The statement is incorrect with regard to both EPE and probability of survival.
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Topic 32 Cross Reference to GARP Assigned Reading – Siddique and Hasan, Chapter 4
C o n c e p t C h e c k e r A n s w e r s
1. C Expected exposure measures the mean distribution of exposures at a given future date prior
to the maturity of the longest maturity exposure in the netting group.
2. D Treating CCR as a market risk allows an institution to hedge market risk losses; however, it leaves the institution exposed to declines in counterparty creditworthiness and default. CCR can be hedged by the ongoing replacement of contracts with a counterparty instead of waiting for default to occur.
3. B The analyst is correct to state that aggregating stress results is not meaningful. Simply taking
the sum of all exposures only considers the loss that would occur if all counterparties were to simultaneously default. This is an unlikely scenario. The analyst s statement on credit quality of the counterparty is incorrect since stresses do not factor in the credit quality of the counterparty.
4. A A financial institution does not need to consider aggregating stresses to the EPE with its loan portfolio, because loans are not sensitive to market variables and, therefore, will not have any exposure changes from changes in market variables.
5. C The BCVA formula differs from the CVA formula in that BCVA incorporates negative
expected exposure (NEE), and the probability of the counterpartys survival must be included in the BCVA formula.
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The following is a review of the Credit Risk Measurement and Management principles designed to address the learning objectives set forth by GARP. This topic is also covered in:
C r e d i t S c o r in g a n d R e t a il C r e d i t R i s k M a n a g e m e n t
Topic 33
E x a m F o c u s
This topic examines credit risk management, primarily from the perspective of the retail credit lender. For the exam, focus on the risks incurred by a lender and how credit scoring models can be used to incorporate variables into an effective risk evaluation model. While estimating risk and evaluating model performance is critical, assessing credit applicants for potential profitability is also important. Be familiar with the role of a credit applicant as both a borrower and a potential client for other lender products. Also, understand the concept of risk-based pricing and how it has changed the way that lenders price their products to different customers.
R e t a i l B a n k i n g R i s k s

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