Economic Capital for Counterparty Credit Risk

Evan Picoult, David Lamb

COUNTERPARTY CREDIT EXPOSURE

Economic capital (EC) is a measurement of economic risk from an insolvency perspective. The measurement of EC for counterparty credit risk is conceptually more difficult than it is for a loan portfolio for three reasons: (a) the uncertainty in the future credit exposure, (b) the bilateral nature of counterparty credit exposure (ie, each party to a forward or swap has potential credit exposure to the other) and (c) the challenge of defining the credit value adjustment (CVA) to take into account the effect of market spreads on the market value of a derivative portfolio with a counterparty.

This chapter has five sections: (1) an introduction to issues surrounding the measurement of counterparty exposure and counterparty risk; (2) a description of the method for measuring a counterparty’s credit exposure profile on a portfolio basis; (3) a summary of the fundamental issues for measuring EC for a loan portfolio from a potential default-only and a potential loss-of-economic-value perspective; (4) a description of the method for measuring EC for counterparty risk from a potential default-only perspective; (5) a description of the method for measuring EC for

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