Counterparty CreditRiskinDerivativesChapter 17RiskManagementandFinanciallnstitutions3e,Chapter17,CopyrightJohnC.Hull2012
Risk Management and Financial Institutions 3e, Chapter 17, Copyright © John C. Hull 2012 Counterparty Credit Risk in Derivatives Chapter 17 1
ClearingArrangements forOTCDerivatives (Figure 17.2, page 381)Bilateral clearing: usually governed by an ISDAMaster agreementCentral clearing: a central clearing party (CCP)stands between the two sidesBilateral ClearingClearingthrougha single CCPRiskManagementandFinancialInstitutions3e,Chapter17,CopyrightJohnC.Hull20122
Clearing Arrangements for OTC Derivatives (Figure 17.2, page 381) ⚫ Bilateral clearing: usually governed by an ISDA Master agreement ⚫ Central clearing: a central clearing party (CCP) stands between the two sides Risk Management and Financial Institutions 3e, Chapter 17, Copyright © John C. Hull 2012 2
RegulationsStandard OTC transactions must be cleared througha CcP (some exceptions)Nonstandard OTC transactions continue to becleared bilaterally, but with much higher capitalchargesRiskManagementandFinancialInstitutions3e,Chapter17,CopyrightJohnC.Hull20123
Regulations ⚫ Standard OTC transactions must be cleared through a CCP (some exceptions) ⚫ Nonstandard OTC transactions continue to be cleared bilaterally, but with much higher capital charges Risk Management and Financial Institutions 3e, Chapter 17, Copyright © John C. Hull 2012 3
Central Clearing: Role of CCP(Figure17.1,page380)TheOTCTrade5%CompanyCompanyBALIBORRoleofCCP5%5%CompanyCompanyCCPBALIBORLIBORRiskManagementandFinancialInstitutions3e,Chapter17,CopyrightJohnC.Hull20124
Central Clearing: Role of CCP (Figure 17.1, page 380) Risk Management and Financial Institutions 3e, Chapter 17, Copyright © John C. Hull 2012 4
KeyQuestionsHow many CCPsWill there be interoperability? Will benefits of netting increase ordecrease?5RiskManagementandFinancialInstitutions3e,Chapter17,CopyrightJohnC.Hull2012
Key Questions ⚫ How many CCPs ⚫ Will there be interoperability? ⚫ Will benefits of netting increase or decrease? Risk Management and Financial Institutions 3e, Chapter 17, Copyright © John C. Hull 2012 5
Simple Example:3marketparticipants; 2 product types (Figure17.3,page 382)RACCPDealerDealerExposureafterExposureExposurebilateral nettingafternettingafter nettingincl.CCPexcl.CCP12000AABB100120120Cc2090907040110AveAveRiskManagementandFinancialInstitutions3e,Chapter17,CopyrightJohnC.Hull20126
Simple Example: 3 market participants; 2 product types (Figure 17.3, page 382) Risk Management and Financial Institutions 3e, Chapter 17, Copyright © John C. Hull 2012 6
Bilateral Clearing:The ISDAMasterAgreement One important feature is nettingThis states that all transactions with thecounterparty are considered to be a singletransaction in the case of early terminationand for the purposes of posting collateral7RiskManagementandFinancialInstitutions3e,Chapter17,CopyrightJohnC.Hull2012
Bilateral Clearing:The ISDA Master Agreement ⚫ One important feature is netting ⚫ This states that all transactions with the counterparty are considered to be a single transaction in the case of early termination and for the purposes of posting collateral Risk Management and Financial Institutions 3e, Chapter 17, Copyright © John C. Hull 2012 7
Events of Default and EarlyTermination.Declaration of bankruptcy Failure to make payments on derivativesas they are dueFailure to provide collateral when it is due The non-defaulting party has the right todeclare an early termination event a fewdays after an event of default if there hasbeen no resolution of outstanding issuesRiskManagementandFinancialInstitutions3e,Chapter17,CopyrightJohnC.Hull20128
Events of Default and Early Termination ⚫ Declaration of bankruptcy ⚫ Failure to make payments on derivatives as they are due ⚫ Failure to provide collateral when it is due ⚫ The non-defaulting party has the right to declare an early termination event a few days after an event of default if there has been no resolution of outstanding issues Risk Management and Financial Institutions 3e, Chapter 17, Copyright © John C. Hull 2012 8
Collateral ArrangementsThe credit support annex (CSA) of theISDA Master Agreement specifiesThresholdIndependent AmountMinimum Transfer Amount EligibleSecurities and CurrenciesHaircuts9RiskManagementandFinancialInstitutions3e,Chapter17,CopyrightJohnC.Hull2012
Collateral Arrangements The credit support annex (CSA) of the ISDA Master Agreement specifies ⚫ Threshold ⚫ Independent Amount ⚫ Minimum Transfer Amount Eligible Securities and Currencies ⚫ Haircuts Risk Management and Financial Institutions 3e, Chapter 17, Copyright © John C. Hull 2012 9
Possible ISDA Clause: DowngradeTriggers Specify that in the event of a downgradethe counterparty has certain rights.It might specify that the counterparty canterminate outstanding transactions or thatthe counterparty can require collateralIn AiG's case counterparties could requirecollateral in the event of a downgradebelow AA. This necessitated a hugegovernment bailout.10RiskManagementandFinancialInstitutions3e,Chapter17,CopyrightJohnC.Hull2012
Possible ISDA Clause: Downgrade Triggers ⚫ Specify that in the event of a downgrade the counterparty has certain rights. ⚫ It might specify that the counterparty can terminate outstanding transactions or that the counterparty can require collateral ⚫ In AIG’s case counterparties could require collateral in the event of a downgrade below AA. This necessitated a huge government bailout. Risk Management and Financial Institutions 3e, Chapter 17, Copyright © John C. Hull 2012 10