Section IV: Managing Counterparty Credit Risk
The final section of this book describes the management of counterparty credit risk, which is a critical aspect due to the volatility of financial markets and regulatory changes. We begin by discussing hedging counterparty risk in Chapter 16. CVA essentially represents a complex hybrid derivative payoff that is ultimately very difficult to manage with good precision, even compared, for example, with the hedging of exotic derivatives positions. We look at the theoretical hedging for CVA across both market risk and credit risk. The impact of DVA and collateral is also considered, and the impact of wrong-way risk in the form of cross-gamma is described. We describe the practical hedging strategies that are possible, especially in light of the illiquidity of credit hedges for most counterparties. We will also discuss that, due to effects such as mapping credit spreads, CVA hedging of accounting PnL is not always aligned with the true reduction of economic risk.
CVA may be further complicated by the need for banks to reduce capital requirements for counterparty risk. Not surprisingly such capital requirements have been increased significantly in light of the global financial crisis. However, these are made up from a combination of different capital charges. Pre-crisis, CVA default losses were capitalised via the Basel I and II frameworks, which considered default risk analogously to illiquid credit risk such as loans. A key part of the ...
