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Counterparty Credit Risk: The new challenge for global financial markets by Jon Gregory

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Chapter 4

Quantifying Counterparty Credit Exposure, I

“The trouble with our times is that the future is not what it used to be.”

Paul Valery (1871–1945)

A key function of the risk management department of a financial institution is the quantification of counterparty credit exposure. In this chapter we characterise and explain how to quantify credit exposure, a key component in determining counterparty risk. Credit exposure is often considered a purely market risk component with no default-related aspects and indeed, as we shall explain, will often be calculated without any reference to the credit quality of the counterparty with which the exposure exists. We would furthermore expect the quantification of credit exposure to have many parallels to market risk as seen in traditional value-at-risk models. Whilst this is true, we will see that there is a key difference between quantifying market risk and credit exposure, which is that for the latter we must often consider a much longer time horizon.

4.1 QUANTIFYING CREDIT EXPOSURE

Quantifying exposure is important for the following reasons:

  • trade approval by comparing against credit lines;
  • pricing (and hedging) counterparty risk;
  • calculating economic and regulatory capital.

We present an overview of the various methods to quantify exposure. These vary from the simple but crude to the more complex generic approach of Monte Carlo simulation. The practical calculation of exposure involves choosing a balance between sophistication ...

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