ERM-124-15: Counterparty Credit Risk - Ch.2: Defining Counterparty Credit Risk



Reading Source: Textbook - Counterparty Credit Risk

Topics Covered in this Reading:

  • Introducing Counterparty Risk
    • Origins of Counterparty Risk
    • Repos
    • Exchange-Traded Derivatives
    • OTC Derivatives
    • Counterparty Risk
    • Counterparty Risk Vs Lending Risk
    • Mitigating Counterparty Risk
    • Counterparty Risk Players
  • Components and Terminology
    • Credit Exposure
    • Default Probability and Credit Migration
    • Recovery
    • Mark-to-Market
    • Replacement Cost
    • Exposure
    • Exposure as a Short Option Position
    • Potential Future Exposure (PFE)
  • Controlling Counterparty Credit Risk
    • Trading with high-quality Counterparties
    • Cross-product Netting
    • Close-out
    • Collateralisation
    • Walkaway Features
    • Monolines
    • Diversification of Counterparty Risk
    • Exchanges and Centralized Clearing Houses
  • Quantifying Counterparty Risk
    • Credit Lines
    • Pricing Counterparty Risk
    • Hedging Counterparty Risk
    • Capital Requirements and Counterparty Risk
  • Metrics for Credit Exposure
    • Expected MtM
    • Expected Exposure
    • Potential Future Exposure
    • EE and PFE for a Normal Distriubtion
    • Overview of Exposure Metrics
    • Expected Positive Exposure
    • Effective EPE
    • Maximum PFE

ERM-124-15: Counterparty Credit Risk: The New Challenge for Global Financial Markets - Ch.2: Defining Counterparty Credit Risk


We are told that many institutions use repurchase agreements (repos) as a liquidity management tool to swap cash against collateral for a pre-defined period.

How exactly does this work? How is this a liquidity management tool?



Hi MattyM,

Essentially, repos are used to sell an asset to another party with the agreement to buy it back at a later date (for a slightly higher price). So the selling party essentially receives cash now and will have to pay back the money plus a little extra (consider it like the interest payment in a loan) at a later date. The fact that the loan involves an actual asset, the loan is collateralized and is considered to be a safer transaction for both parties. This has led to a massive amount of repo agreements being available in the market now. Short term cash needs can be satisfied by entering into a short-term repo agreement. This is how these items can be used to manage liquidity.


Hi all,
I’ve questions about Expected MtM and Expected Exposure…
I understand that Expected MtM is the value of MtM at some point in the future. How is Expected MtM calculated ? in a deterministic way or with a set of scenarios ?
Is Expected Exposure also the value of Exposure at some point in the future ? It is not really clear for me in the document.


I would invite someone who’s worked more closely with credit risk to comment on how this is determined in practice! My guess is that stochastic models would usually be used to determine the value of contracts under many different scenarios. But perhaps if a simple approach is needed, a deterministic way would be used.

The expected exposure is really just the positive value of the MtM. MtM can be positive or negative (indicating whether the contract would currently an outflow or an inflow). When MtM is positive, it represents a potential loss, which is considered an exposure. In other words, Exposure = Max(0,MtM). So the expected exposure is the expected value of this measure at some point in time.

Note: The EE will be greater than the Expected MtM as it only concerns itself with positive MtM


Thanks a lot


In terms of controlling counterparty risk, what is the difference between “Close-out” and “Walk-away” features? Is it that with a walk-away you don’t have to pay the counterparty even if you have a negative MtM, where as with a close-out you still do? Thanks!


That is my understanding, yes! Walk-away features allow you to immediately cancel the contract upon default like it never existed (you would only want to do this if you OWED money, not if the defaulted counterparty owed you money). With close-out features, you would still have to pay money owed to the counterparty, but you can reduce this payment by netting it against what is owed to you