Relevance
PFE is essential to bank regulation under Basel III and Dodd Frank. Fundamentally, to assess the safety of a bank's asset portfolio and the adequacy of its Tier 1 capital (and Tier 2 capital), one needs to evaluate whether it is resilient under severely stressing market moves. Because PFE is a measure of credit exposure, the most relevant stress move for PFE are not those where a large trading loss occurs (as they are when considering an institution's market risk). Instead, the scenarios of significant PFE can often be where the institution makes a large "paper" profit with a counterparty; and therefore accrues a large unsecured claim on that counterparty (a claim that the counterparty may be unable to pay). For example, a trader might be cheap insurance contracts against a rare but catastrophic risk. The vast majority of the time – and for many years running – the trader will make a small annual loss (the CDS premium) even if the trade has positive expected value. When the rare event occurs, the trader may suddenly have a huge windfall "profit" claim against whoever wrote the "insurance". And this would mean a sudden increase in the relevance of whether or not the 'insurance writing' counterparty can actually pay. The possibility that the counterparty cannot pay (this huge new claim) would create a systematically important difference between the theoretical-credit-risk-free profits of the trader (and his institution) and his realized year end profit. Since institutional market risks are hedged, this difference could impact the institution's capital not merely as a failure to make excess profits, but actually as a significant net loss (due to losses on the offsetting hedge position). And potentially, exposure to such credit losses could make the "profit-making" trader's institution fail (and default on its own obligations to other companies) thereby causing other companies to suffer credit risk losses and fail (in the same way). The theoretical potential for a cascading series of institutional failures (caused by sudden rises in PFE) is apparent. The cost of avoiding or dealing with these risks can fall on the public (the vast majority of whom will not gain directly from the institutional profits made while accruing large PFE claims). This is for two main reasons. First, government directly (or indirectly) insures many retail deposits (to prevent bank runs and to promote savings), and many quasi-government agencies (e.g.: FNMA, Freddie Mac) have de facto government backing. Second, even when a major firm does not have government insured deposits, it can be "systemically important" (such as AIG) – its failure would potentially cause panic, destroy market liquidity, and precipitate a crash and potential widespread economic contraction / depression. One plan that is intended to reduce the public cost (& private benefit) of the implicit support to "too big to fail" institutions is to reduce the variability and scale of PFE by incentivizing collateralization.
In finance, a derivative is a contract that derives its value from the performance of an underlying entity. This underlying entity can be an asset, index, or interest rate, and is often simply called the "underlying". Derivatives can be used for a number of purposes, including insuring against price movements (hedging), increasing exposure to price movements for speculation or getting access to otherwise hard-to-trade assets or markets. Some of the more common derivatives include forwards, futures, options, swaps, and variations of these such as synthetic collateralized debt obligations and credit default swaps. Most derivatives are traded over-the-counter (off-exchange) or on an exchange such as the New York Stock Exchange, while most insurance contracts have developed into a separate industry. In the United States, after the financial crisis of 2007–2009, there has been increased pressure to move derivatives to trade on exchanges. Derivatives are one of the three main categories of financial instruments, the other two being stocks and debt. The oldest example of a derivative in history, attested to by Aristotle, is thought to be a contract transaction of olives, entered into by ancient Greek philosopher Thales, who made a profit in the exchange. Bucket shops, outlawed in 1936, are a more recent historical example.
In finance, a credit derivative refers to any one of "various instruments and techniques designed to separate and then transfer the credit risk" or the risk of an event of default of a corporate or sovereign borrower, transferring it to an entity other than the lender or debtholder.
A credit default swap (CDS) is a financial swap agreement that the seller of the CDS will compensate the buyer in the event of a debt default or other credit event. That is, the seller of the CDS insures the buyer against some reference asset defaulting. The buyer of the CDS makes a series of payments to the seller and, in exchange, may expect to receive a payoff if the asset defaults.
A credit risk is the risk of default on a debt that may arise from a borrower failing to make required payments. In the first resort, the risk is that of the lender and includes lost principal and interest, disruption to cash flows, and increased collection costs. The loss may be complete or partial. In an efficient market, higher levels of credit risk will be associated with higher borrowing costs. Because of this, measures of borrowing costs such as yield spreads can be used to infer credit risk levels based on assessments by market participants.
Mark-to-market or fair value accounting refers to accounting for the "fair value" of an asset or liability based on the current market price, or the price for similar assets and liabilities, or based on another objectively assessed "fair" value. Fair value accounting has been a part of Generally Accepted Accounting Principles (GAAP) in the United States since the early 1990s, and is now regarded as the "gold standard" in some circles. Failure to use it is viewed as the cause of the Orange County Bankruptcy, even though its use is considered to be one of the reasons for the Enron scandal and the eventual bankruptcy of the company, as well as the closure of the accounting firm Arthur Andersen.
A repurchase agreement, also known as a repo, RP, or sale and repurchase agreement, is a form of short-term borrowing, mainly in government securities. The dealer sells the underlying security to investors and buys them back shortly afterwards, usually the following day, at a slightly higher price.
Liquidity risk is a financial risk that for a certain period of time a given financial asset, security or commodity cannot be traded quickly enough in the market without impacting the market price.
Financial risk is any of various types of risk associated with financing, including financial transactions that include company loans in risk of default. Often it is understood to include only downside risk, meaning the potential for financial loss and uncertainty about its extent.
In finance, margin is collateral that the holder of a financial instrument has to deposit with a counterparty to cover some or all of the credit risk the holder poses for the counterparty. This risk can arise if the holder has done any of the following:
Loss given default or LGD is the share of an asset that is lost if a borrower defaults.
Exposure at default or (EAD) is a parameter used in the calculation of economic capital or regulatory capital under Basel II for a banking institution. It can be defined as the gross exposure under a facility upon default of an obligor.
A central clearing counterparty (CCP), also referred to as a central counterparty, is a financial institution that takes on counterparty credit risk between parties to a transaction and provides clearing and settlement services for trades in foreign exchange, securities, options, and derivative contracts. CCPs are highly regulated institutions that specialize in managing counterparty credit risk.
Collateral has been used for hundreds of years to provide security against the possibility of payment default by the opposing party in a trade. Collateral management began in the 1980s, with Bankers Trust and Salomon Brothers taking collateral against credit exposure. There were no legal standards, and most calculations were performed manually on spreadsheets. Collateralisation of derivatives exposures became widespread in the early 1990s. Standardisation began in 1994 via the first ISDA documentation.
A synthetic CDO is a variation of a CDO that generally uses credit default swaps and other derivatives to obtain its investment goals. As such, it is a complex derivative financial security sometimes described as a bet on the performance of other mortgage products, rather than a real mortgage security. The value and payment stream of a synthetic CDO is derived not from cash assets, like mortgages or credit card payments — as in the case of a regular or "cash" CDO — but from premiums paying for credit default swap "insurance" on the possibility that some defined set of "reference" securities — based on cash assets — will default. The insurance-buying "counterparties" may own the "reference" securities and be managing the risk of their default, or may be speculators who've calculated that the securities will default.
This article provides background information regarding the subprime mortgage crisis. It discusses subprime lending, foreclosures, risk types, and mechanisms through which various entities involved were affected by the crisis.
Credit valuation adjustment (CVA) is the difference between the risk-free portfolio value and the true portfolio value that takes into account the possibility of a counterparty's default. In other words, CVA is the market value of counterparty credit risk. This price depends on counterparty credit spreads as well as on the market risk factors that drive derivatives' values and, therefore, exposure. CVA is one of a family of related valuation adjustments, collectively xVA; for further context here see Financial economics § Derivative pricing.
The ISDA Master Agreement, published by the International Swaps and Derivatives Association, is the most commonly used master service agreement for OTC derivatives transactions internationally. It is part of a framework of documents, designed to enable OTC derivatives to be documented fully and flexibly. The framework consists of a master agreement, a schedule, confirmations, definition booklets, and credit support documentation.
Under the Basel II guidelines, banks are allowed to use their own estimated risk parameters for the purpose of calculating regulatory capital. This is known as the internal ratings-based (IRB) approach to capital requirements for credit risk. Only banks meeting certain minimum conditions, disclosure requirements and approval from their national supervisor are allowed to use this approach in estimating capital for various exposures.
An X-Value Adjustment is a generic term referring collectively to a number of different “Valuation Adjustments” in relation to derivative instruments held by banks. The purpose of these is twofold: primarily to hedge for possible losses due to counterparty default; but also, to determine the amount of capital required under Basel III. For a discussion as to the impact of xVA on the bank's overall balance sheet, return on equity, and dividend policy, see: XVA has, in many institutions, led to the creation of specialized desks. Note that the various XVA require careful and correct aggregation without double counting.
The Standardized approach for counterparty credit risk (SA-CCR) is the capital requirement framework under Basel III addressing counterparty risk. It was published by the Basel Committee in March 2014.
