The Evolution of Stress Testing Counterparty Exposures

David Lynch

The call for better stress testing of counterparty credit risk exposures has been a common occurrence from both regulators and industry in response to financial crises (CRMPG I 1999; CRMPG II 2005; FRB 2011). Despite this call, statistical measures have progressed more rapidly than stress testing. In this chapter we examine how stress testing may be improved by building off the development of the statistical measures. We begin by describing how the measurement of counterparty risk has developed by viewing the risk as a credit risk and as a market risk. The problems this creates for a risk manager who is developing a stress-testing framework for counterparty risk are then identified. Methods to stress-test counterparty risk are described from both a credit risk perspective and from a market risk perspective, starting with the simple case of stressing current exposures to a counterparty. These stress tests are considered from both a portfolio perspective and individual counterparty perspective. Last, some common pitfalls in stress testing counterparty exposures are identified.

The Evolution of Counterparty Credit Risk Management

The measurement and management of counterparty