Frequently Asked Questions - Credit Risk

Credit Risk

      This section gives a more detailed breakdown of the functionality that is available in the credit risk section of the website. Within RiskSystem, there are two techniques currently available for the estimation of Credit Risk, these are Credit Value Adjustment and Credit Risk Matrix.

      The second section, Counterparty Credit Risk determines estimates of potential future exposure to an individual counterparty or to an aggregate set of counterparties. This analysis is driven by considerations such as counterparty risk management, efficient allocation of economic capital and regulatory risk reporting. This section does not purport to be a comprehensive description of counterparty credit analysis, but to give users of this site information of hte models techniques and approximations that are used in order to generate the appropriate risk statistics.

Credit Value Adjustment: CVA

       Credit Value Adjustment is most probably the single most important number in counterparty credit risk. It may be thought of as the market price of having financial exposure (both now and in the future) to counterparties whose default probabilites are not zero. It may be interesting to speculate on the actual existence of any zero default probability counterparties, but not particularly fruitful. In other words, to remove the credit risk associated with a counterparty, this is the amount that you should pay, most likely to a zero default probability counterparty, if you can find one.

       As such, from a regulatory prespective, it would be appropriate to put away a sum of this magnitude as reserve capital to protect against losses arising from the realisation of couterparty defauls.

Effective Expected Exposure: EEE

      If one holds credit sensitive fixed maturity instruments as part of a portfolio, the EE of these instruments (see below) will decline as one approaches the maturity of the instrument. This is incompatible with the second law of finodynamics which has it that risk is either constant or increasing in a system. The effective expective exposure is defined as the maximum value of the EE that has been achieved between the start of the anaylsis and the current time point. As it is either increasing or constant, it is consistent with the second law.

Expected Exposure: EE

      This is defined as the positive outcome weighted exposure to a given counterparty. It only is concerned with positive exposures because a negative exposure to a counterpary at that counterparty's default has little or no implications from a capital loss perspective. There is obviously an unexpected risk exposure (which may be significant) and a liquidity exposure, but they are ignored in the definition of Expected Exposure. Probably sub-optimal from a risk perspective. Definitely looks better from a tractability perspective.

Expected Positive Exposure: EPE

      If one holds credit sensitive fixed maturity instruments as part of a portfolio, the EE of these instruments will decline as one approaches the maturity of the instrument. This is incompatible with the second law of finodynamics which has it that risk is either constant or increasing in a system. As such EPE is defined as the average of the EE of the instrument over the life of the instrument. As such it is constant and thus consistent.

Wrong Way Risk

      From a counterparty credit perspective, wrong way risk is that type of credit exposure that has a positive correlation between the magnitude of the exposure and the probability of default of the counterparty. In a linear worls this can be a serious issue. In a concave world, associated with second order phase transition type events such as default, this can be catastrophic.

      A very simplified example is where you are short the market with a counterparty who is long the market, and the size of their long position is much greater than your short. As and when the market declines your positive exposure with the counterpary increases, whilst at the same time their probability of default effectively increases due to their losses, all other things being equal. Wrong way risk need careful identification and monitoring so as to mitigate its baneful impact.