Credit Derivatives: Trading, Investing and Risk Management, Second Edition

5

Traditional Counterparty Risk Management

5.1 VETTING

Counterparties risk arises from interest rate swap trades, credit default swap trades and many other deals. The first counterparty risk control measure is to accept as a possible counterparty to a deal only those entities which are (for example)

a. regulated by a central bank or insurance regulator

b. rated A (or possibly BBB) or better

c. domiciled in certain countries.

Counterparties which do not meet these criteria will generally not be accepted as counterparties without other conditions being met - for example full collateral being posted or being accepted for certain types of trades or maturities only.

The intention of these restrictions is clearly to accept only ‘low risk’ counterparties. Even once a counterparty has been deemed an acceptable risk further measures described below are taken to control the risk on individual deals.

5.2 COLLATERALISATION AND NETTING

The second step (not always applied to all counterparties or to all products for a given counterparty) is to require that the counterparty ‘collateralises’ deals and signs a ‘netting’ agreement.

Collateralisation means that each deal is marked to market (and both sides have to agree on this value) and any change in the value from one day to the next is matched by a cashflow from one counterparty to the other. Thus a mature deal - for example, an interest rate swap or default swap that had an initial value of zero - may have moved to being a USD2m positive ...