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

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Chapter 5

Quantifying Counterparty Credit Exposure, II - The Impact of Collateral

“There is no security on this earth, there is only opportunity.”

General Douglas MacArthur (1880–1964)

5.1 INTRODUCTION

In this chapter we describe the quantification of credit exposure in the presence of collateral. The use of collateral has become so widespread that such considerations must be given a detailed assessment. Collateral typically reduces exposure but there are many sometimes subtle points that must be considered in order to properly assess the true extent of any risk reduction. To properly account for the real impact of collateral, parameters such as thresholds and minimum transfer amounts must be properly understood and represented appropriately. Furthermore, the margin period must be carefully analysed to determine the true period of risk with respect to collateral transfer.

As mentioned previously, whilst collateralisation is a risk mitigation technique, it gives rise to many potential new risks, which must be thoroughly appreciated. In the event of two-way collateral agreements, collateralisation can increase exposure due to effects such as rehypothecation (discussed in Chapter 3) or the inability to retrieve cash from a defaulted counterparty. Collateralisation also creates other risks, such as operational risk, FX risk and liquidity risk. Effective collateral management is only possible if all of these risks are well-understood and properly managed.

5.2 THE IMPACT OF COLLATERAL ...

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