casemark/managing-counterparty-risk

Managing Counterparty Risk

When To Use

• Onboarding a new derivatives, lending, or repo counterparty and setting initial credit limits
• Periodic (quarterly/annual) review of existing counterparty exposures against approved limits
• Calculating potential future exposure (PFE) or credit valuation adjustment (CVA) for a portfolio
• Evaluating collateral adequacy after a credit event, rating downgrade, or material market move
• Preparing counterparty risk reports for risk committees, regulators, or senior management
• Assessing netting and close-out enforceability under ISDA or equivalent master agreements

Inputs To Gather

• Counterparty profile: Legal entity name, LEI, corporate structure, domicile, sovereign rating
• Credit assessment data: External ratings (S&P, Moody's, Fitch), internal scorecard results, CDS spreads, financial statements (most recent 2-3 periods)
• Exposure data: Trade-level mark-to-market by product (derivatives, repo, securities lending, loans), notional amounts, maturity profiles
• Netting & collateral documentation: ISDA master agreement status, CSA/VM-CSA terms (thresholds, minimum transfer amounts, eligible collateral, haircuts), netting opinion coverage [VERIFY jurisdiction-specific enforceability]
• Limit framework: Approved credit limits by exposure type (current exposure, PFE, settlement risk), tenor buckets, and any sub-limits by product or desk
• Regulatory parameters: SA-CCR or IMM methodology inputs, risk weights, CVA capital charge requirements [VERIFY applicable framework: Basel III / Basel IV / local implementation]

Workflow

1. Profile the counterparty

   • Confirm legal entity, group hierarchy, and ultimate parent
   • Map to internal rating grade using scorecard or external rating mapping
   • Determine probability of default (PD) and loss given default (LGD) assumptions
   • Flag any wrong-way risk — correlation between counterparty creditworthiness and exposure direction

2. Calculate exposure metrics

   • Compute current exposure (CE): aggregate positive MTM after legally enforceable netting
   • Estimate potential future exposure (PFE) at defined confidence interval (typically 95th or 97.5th percentile) across relevant time horizons (1-day, 10-day, 1-year, life-of-trade)
   • Derive expected exposure (EE) and expected positive exposure (EPE) profiles for CVA pricing
   • For SA-CCR: compute replacement cost (RC) and PFE add-on by asset class (interest rate, FX, credit, equity, commodity) [VERIFY regulatory multipliers and supervisory factors]

3. Assess collateral and mitigation

   • Verify CSA terms: threshold, independent amount, minimum transfer amount, frequency of margin calls
   • Calculate net unsecured exposure after applying collateral (cash, government bonds, other eligible assets with appropriate haircuts)
   • Review initial margin (IM) adequacy for cleared vs. bilateral trades
   • Evaluate guarantees, credit insurance, or CDS hedges and their effectiveness
   • Confirm netting opinion validity for counterparty jurisdiction [VERIFY local netting enforceability]

4. Test against limits and triggers

   • Compare CE, PFE, and settlement exposure against approved counterparty limits
   • Identify limit breaches, near-breaches (e.g., >80% utilization), and tenor concentrations
   • Check for credit event triggers: rating downgrade clauses, additional termination events (ATEs), cross-default provisions
   • Run stress scenarios: counterparty default under adverse market conditions, jump-to-default, simultaneous collateral devaluation

5. Compile risk report and recommendations

   • Summarize exposure profile with trend analysis (current vs. prior period)
   • Present limit utilization dashboard by counterparty, product, and tenor
   • Highlight watch-list counterparties and escalation items
   • Recommend actions: limit adjustments, additional collateral calls, trade compression or novation, hedging via CDS

Output

The counterparty risk report should contain:

• Executive summary: Top 10 exposures, aggregate portfolio PFE, notable changes since last review
• Individual counterparty cards: Rating, PD/LGD, CE/PFE, limit utilization, collateral coverage ratio, wrong-way risk flag
• Exposure analytics: Breakdown by asset class, maturity bucket, and netting set; concentration metrics (Herfindahl index or top-N share)
• Stress test results: Impact of defined scenarios on exposure and collateral values
• Action items: Specific limit changes, margin call recommendations, documentation remediation (e.g., outstanding netting opinions or CSA amendments)
• Regulatory capital impact: SA-CCR EAD or IMM exposure, CVA capital charge delta [VERIFY capital framework in effect]

Quality Checks

• Verify that netting is applied only where a valid, current netting opinion exists for the relevant jurisdiction
• Confirm PFE model parameters (volatilities, correlations, confidence level) are consistent with approved methodology
• Cross-check MTM values against independent valuation sources (front-office vs. risk system reconciliation)
• Ensure haircuts on collateral reflect current market conditions and regulatory minimums
• Validate that wrong-way risk exposures are separately identified and not netted against general exposure
• Confirm all limit breaches have documented escalation and remediation timelines
• Check that rating downgrade trigger analysis reflects current CSA/ISDA terms, not stale documentation