Measuring Counterparty Credit Risk for Trading Products under Basel II

Abstract

We described the treatment of counterparty credit risk of OTC derivatives under Basel II. According to this framework, minimum capital requirements for counterparty credit risk are to be calculated according to the corporate loan rules applied to the appropriate exposure at default (EAD) calculated at the netting set level. We present both Non-Internal and Internal Model Methods (IMM) of calculating this EAD. To obtain supervisory approval for the IMM, banks must be able to calculate expected exposure at the netting set level for a set of future dates. We also discussed a modeling framework that can be used for calculating exposure distribution at a set of future dates and, in particular, for calculating expected exposure profiles. This framework can be used for both regulatory and internal purposes. Additionally, we explained the treatment of margin agreements under the IMM that allows one to calculate the collateralized EPE measures: modeling collateralized exposure and the Shortcut Method. We discussed a general approach to modeling collateralized exposure that enables one to compute the collateral at a future date as a function of uncollateralized exposure at another date that precedes the primary date by the margin period of risk. Finally, we suggested a simple and fast method under this approach for modeling collateral that avoids the simulation of exposure at the secondary dates.

Keywords: Basel II, Collateral, Credit Exposure, Regulatory Capital and Counterparty Credit Risk