Counterparty risk & counterparty valuation adjustment

Thomas Saugstrup Rieck

Student thesis: Master thesis


Since the credit crisis began in 2007, banks have been put under a lot of pressure to decrease their exposure and thereby: risk against counterparties. The reason for this is the rather poor control and surveillance, banks had against impacts in market changes to their positions, especially in the OTC market. This came to show, when Lehman went bankrupt in September 2008 as the first large investment bank, due to a very skewed credit derivative market, where e.g. especially CDS contracts were becoming a speculative instrument, rather than a hedging instrument as intended. Later when the American insurance company, AIG had to be rescued by the American government, it was clear, that the default of Lehman was not a unique case, and that the global economy faced a potential collapse. This led to increased regulatory control of financial institutions and their ability to capture any potential loss in the future, with the BIS’ Basel Committee, as the committee to suggest new ways to regulate the financial institutions. The credit and counterparty area was one of the first areas where banks, among other financial institutions, were required to increase their control processes. An expected future exposure measure was to be reported on a daily basis in banks daily accounting. This would show the impact on all the banks portfolios, based on daily changes in the market. Also solvency requirements were tightened, which meant banks were struggling to reach the minimum required solvency target, and some even gave in and defaulted. In the meantime, spreads, which is a figure that combines the market’s expectations of a default by a company or country with the rating and the loss given default if a company or country defaults, were growing and kept pushing nervousness and volatility into the market. Still the BIS Basel Committee was working on a way to ensure banks being in business tomorrow, by making sure they did not default due to counterparties not being able to fulfill their obligations stated in a bilateral contract with the bank. Banks were working on lowering their risk by hedging almost all exposed market- and credit positions to minimize the amount being subtracted from their portfolio accounts, in order to satisfy their stockholders expected return on capital. This paper will take the reader through relevant factors and instruments that contribute to a banks exposures toward counterparties in the OTC market, and explain through an interest rate swap, how market risks and credit risks effect a banks overall risks. The paper will give the reader an insight to the CVA measure, which is the risk measure the BIS Basel Committee introduced in November 2010, as the new regulatory initiative to ensure a high capitalization of the banks for the safety of its customers and stockholders. The paper will walk the reader through calculations of CVA and explore solutions to how banks might minimize or completely hedge the CVA measure within the requirements stated in Basel III, if possible. The paper ends by discussing the way forward for banks, in a way where they can still keep doing business and still live up to all regulatory requirements as well as keeping their return on equity promises to their stockholders.

EducationsMSc in Finance and Accounting, (Graduate Programme) Final Thesis
Publication date2011
Number of pages100