Counterparty Credit Risk (CCR) – In-depth Overview with Focus on Key

Metrics and Terms

Counterparty Credit Risk (CCR) is the risk that the counterparty to a financial contract
(such as a derivative, repo, or securities financing transaction) will default before the
contract's final settlement, and thus, the bank or financial institution might incur a loss due to
the exposure to this counterparty.

Managing CCR involves a variety of metrics, stress tests, and add-ons to ensure banks have
adequate capital and risk management in place. Let's dive into the key concepts and metrics
you mentioned, including D0 Stress Measures, SLVE, SLVM Exposure, Basis Add-on,
Concentration Add-on, and more.

1. D0 Stress Measures

D0 Stress Measures refer to the measures used to assess counterparty risk under stress
conditions, particularly the exposure at the most critical point—typically at the start of the
transaction (Day 0). These stress measures help identify how much potential exposure a
bank might have at the outset, taking into account worst-case market conditions.

Key stress testing principles include:

 Extreme but plausible scenarios: Stress tests simulate market shocks, such as severe
movements in interest rates, credit spreads, or equity prices.
 Stressed Exposure: Estimation of the maximum exposure under stressed market
conditions at Day 0.
 Market shocks: Changes in prices, interest rates, credit spreads, etc., to evaluate how
much risk the bank could be exposed to if a counterparty defaults.

D0 stress measures are critical for Initial Margin calculations and for determining how much
collateral is needed to mitigate this early exposure.

2. SLVE and SLVM Exposure

 SLVE (Stress Loss Valuation Exposure): SLVE represents the market value of a
bank's exposures to a counterparty, including potential future exposure (PFE)
calculated under stress conditions.
o It quantifies the exposure under a scenario where the bank is concerned about
market stress and counterparty defaults.
o SLVE combines both the current mark-to-market value of the trades and adds
potential stress scenarios that could worsen exposure.
 SLVM (Stress Loss Valuation Margin): SLVM refers to the stress-tested value of
the margin posted or received by the bank to cover CCR.
 o It is the margin requirement under stressed conditions and evaluates how
much additional margin would be needed to protect against the risk of the
counterparty defaulting under adverse conditions.
o SLVM helps ensure the collateral buffer is sufficient to mitigate exposure
volatility during stressed conditions.

Together, SLVE and SLVM measure the overall exposure of a bank under stressed
conditions, considering both the credit risk of the counterparty and the effectiveness of the
collateral/margin posted.

3. Basis Add-on

Basis Add-ons are additional capital charges or adjustments made to capture the basis risk
between different instruments or markets that are theoretically related but behave differently
in practice.

For example:

 Interest Rate Basis Risk: This arises when there is a difference in the rates used for
discounting cash flows (e.g., LIBOR vs. OIS rates).
 Credit Basis Risk: Occurs when there's a discrepancy between the spread used in a
derivative contract versus the actual credit spread of the counterparty.

In CCR, a basis add-on is introduced to account for the fact that basis risks (the risk of
imperfect hedging) may not be fully captured by other models. These are usually small
adjustments, but they ensure that the total risk is not underestimated.

4. Concentration Add-on

Concentration Add-ons reflect the additional capital required due to high exposures to
specific counterparties, sectors, or asset classes.

 Concentration Risk: If a bank has a large proportion of its exposure concentrated in

For example:

 A bank might have excessive exposure to a specific counterparty in the energy sector.
If there’s a sudden downturn in oil prices, the exposure to that counterparty would
increase significantly, raising the risk for the bank.
The concentration add-on helps balance this risk by requiring more capital for highly
concentrated exposures.

5. Directional and Non-Directional Risks

a. Directional Risks

 Directional risks refer to risks that move in a predictable manner with the direction
of the market. These risks have a positive or negative correlation with market
movements. For example, long or short positions in securities, commodities, or
currencies represent directional risks because their value will move in relation to
market price changes.
 In CCR, a directional risk could arise from exposures tied to market factors like
interest rates or equity prices. If the counterparty has a position that aligns with a
market trend, their creditworthiness may improve or deteriorate accordingly.

Example:

 A bank holds derivatives tied to a rise in interest rates. If interest rates increase, the
exposure to the counterparty rises in the same direction, increasing the risk of loss in
the event of default.

b. Non-Directional Risks

 Non-directional risks are risks that are not tied to a specific market movement and
can affect both upward and downward market conditions. These risks include
uncertainties that cannot be hedged with simple directional positions.
 Examples: Correlation risk, spread risk, or funding risk could be classified as non-
directional.

In CCR, non-directional risk captures uncertainties related to liquidity, correlation between

6. Required Margin

The required margin refers to the amount of collateral that needs to be posted by a
counterparty to protect against the potential future exposure (PFE) of a financial transaction.
In the context of CCR, the margin is primarily used in derivative contracts and securities
financing transactions.

 Initial Margin (IM): Collateral posted at the outset of a transaction to cover potential
future exposure under stressed market conditions.
 Variation Margin (VM): The daily collateral posted based on the mark-to-market
movements of the underlying trades.
Banks need to ensure that the required margin is adequate under both normal and stressed
conditions to protect against a potential default by the counterparty.

7. Limit Utilization, Released Limit, Approved Limit

 Limit Utilization: Refers to the portion of the credit limit that a bank has used up
with a particular counterparty. For each counterparty, banks set credit limits to cap
their exposure, and limit utilization tracks how much of that limit is in use at any
given time.
 Released Limit: Refers to the portion of the credit limit that has been freed up after
certain transactions have been settled or exposures have been reduced (e.g., through
collateral or margin posting).
 Approved Limit: The maximum exposure a bank is allowed to have with a given
counterparty, as approved by its internal credit risk committee. This takes into account
the counterparty's creditworthiness, market conditions, and other risk factors.

Effective limit management ensures that the bank doesn’t over-expose itself to any single
counterparty and has enough headroom for future transactions.

8. Reserve

In the context of counterparty credit risk, a reserve refers to the funds or capital set aside to
cover potential losses that could arise from the default of a counterparty.

 Banks set up reserves based on expected credit losses (ECL) calculated using factors
like the probability of default (PD), loss given default (LGD), and exposure at default
(EAD).
 Reserves act as a buffer against unforeseen losses, ensuring that the bank remains
solvent even in the event of large counterparty defaults.

9. CCOL (Close-out Collateral)

CCOL (Close-out Collateral) is a concept used when a counterparty defaults, and the bank
needs to settle or close-out its positions. Close-out collateral represents the amount of
collateral that needs to be collected or retained to offset any potential loss during the close-
out process.

10. Closed-Out Netting Screens

Closed-out netting refers to the process by which all obligations under financial contracts
with a defaulting counterparty are netted to a single amount owed by one party to the other.
This netting process reduces the bank's exposure by allowing it to offset losses on some
contracts with gains on others.

 Netting Screens: These are systems used to display or calculate the results of close-
out netting. They show the net exposure after all the bank's positions with the
counterparty have been consolidated.

This is particularly important in derivatives, where netting agreements can significantly

11. Tenor

Tenor refers to the length of time remaining until a financial contract, such as a derivative or
loan, expires. In CCR, tenor is crucial for determining the exposure and required collateral.

 Longer tenors typically mean higher exposure because there’s more time for market
volatility or adverse events to affect the counterparty’s ability to meet its obligations.
 Shorter tenors usually involve lower risk as there is less time for the underlying
assets or obligations to move significantly.

Conclusion

Understanding these key terms and metrics is essential for managing Counterparty Credit
Risk (CCR) effectively. Banks need to assess, monitor, and control these exposures using a
combination of stress testing, add-ons, and limit management. The ultimate goal is to
ensure that the bank has enough capital reserves and collateral to mitigate the risk of
counterparty defaults, particularly under stressed market conditions.