Published on

What is Counter-Party Credit Risk (CCR)

Authors
  • avatar
    Name
    Benton Li
    Twitter

Definition: Counter-party credit risk (CCR) is the risk of loss due to a counterparty not full filling the transaction

Huh, sounds like credit risk, are they the same thing?

Before we answer this, let’s ask this:

What is a counter-party exactly?

Let’s say someone borrows money from the bank. If you are the bank, the borrower is your counterparty. If you are the borrower, then the bank is your counterparty.

Yeah, it’s just simple like that.

And back to the question, the answer is not really, although it is primarily a form of credit risk. If you happen to know programming this is what it means

abstract class CounterPartyCreditRisk extends CreditRisk;

CCR is also a form of market risk, because:

  • Either party could be fucked: for example, in an interest rate swap (see example below), both parties can default.
  • Risks change over time: the value of certain derivatives change over time too. For example, option contracts lose their time value over time.
  • Risk exposure can zero: let’s just say you are the borrower, you already got your money and you don’t need to worry about your bank going default or not.

Example of interest rate swap:

A → B: fixed rate

A ← B: floating rate

Note: When the floating rate increases, B pays more, and when the rate decreases, B pays less, consequently, A receives less. Therefore, Both A and B are exposed to interest rate risks

Sources of CCR:

  • Security lending: more like a temporary asset swap. I give you my Tesla stock, you give me a cash collateral. Both parties can default at maturity, i.e. I fail to return you cash or you fail to return my stock.
  • Market-related contracts: e.g. interest rate derivatives
  • Collateralisation: loss of collateral value → you get less upon default → CCR increases

Factors affecting CCR Exposures

Multiple risk factors:

  • Macroeconomic factor: e.g. GDP
  • Markets risk factor: e.g. interest rates, CNY/USD rate
  • Counter-party specific factors: e.g. credit rating

Volatility: which changes value of market risk especially during time of stress

Tenor: tenor longer → more difficult to project & model → risk stonks

Roll-offs: as you get paid off over time you feel happier

Optionality: the value of option contracts is influenced by market price. “To exercise or not to exercise, that is a question.”

Correlation: you don’t really want your exposure at default and probability of default correlates right?

CCR components:

As you know, you better start to look for gas stations when your tank is running low, not when you completely ran of the gas. Likewise, you should assess CCR from time to time and take actions before defaults happen.

In this sense, CCR can be broken down into two parts:

  1. Risk of counterparty default, a settlement risk
  2. Credit Value Adjustment (CVA), a pre-settlement risk.

Notice that CVA is understood as a loss due to your counterparty’s credit worthiness. For example, if you hold bonds issued by Alice, and you heard Bob saying Alice failed to repay the bond, you better start to buy an issuance (like a CDS) for this bond or resell this bond at a cheaper price (pass the vibe!)

How do you measure/CCR?

Bankers answer: per Basel III, SA-CCR or IMM. ← But you don’t need to know about this. If you want to know, you better be paid to learn.

But basically you need to know how exposure at default (EAD), probability of default (PD), and loss given default (LGD) are assessed.

We will talk about EAD and CVA in further posts.