Measuring Counterparty Credit Risk for Trading Products under Basel II

Michael Pykhtin and Steven Zhu

INTRODUCTION

Counterparty credit risk is the risk that the counterparty to a financial contract will default prior to the expiration of the contract and will not make all the payments required by the contract. Only the contracts privately negotiated between counterparties – over-the-counter (OTC) derivatives and security financing transactions (SFT) – are subject to counterparty risk. Exchange-traded derivatives are not affected by counterparty risk because the exchange guarantees the cashflows promised by the derivative to the counterparties. Counterparty risk is similar to other forms of credit risk in that the cause of economic loss is the obligor’s default. There are, however, two features that set counterparty risk apart from more traditional forms of credit risk: the uncertainty of exposure and the bilateral nature of credit risk.

If a counterparty in a derivative contract defaults, the surviving counterparty must close out its position with the defaulting counterparty and enter into a similar contract with another counterparty to maintain its market position. Therefore, counterparty exposure is determined by the contract’s replacement cost at the time of default. Assuming