Counterparty Risk Monitoring
Counterparty risk monitoring tracks credit exposure to OTC derivatives counterparties, identifies deteriorating credits, and triggers risk mitigation actions. Effective monitoring combines quantitative exposure metrics with qualitative credit assessment.
Definition and Key Concepts
What Is Counterparty Risk
Counterparty risk is the risk that the other party to a derivative contract defaults before fulfilling its obligations. This includes:
| Component | Description |
|---|
| Current exposure | Today's mark-to-market if positive |
| Potential future exposure | How exposure could grow |
| Settlement risk | Risk during payment exchange |
| Wrong-way risk | Correlation between exposure and default |
Key Metrics
| Metric | Definition | Use |
|---|
| Current Exposure (CE) | max(0, MTM) | Today's credit exposure |
| Potential Future Exposure (PFE) | 97.5% quantile of future MTM | Credit limit setting |
| Expected Exposure (EE) | Average of positive future MTM | CVA calculation |
| Expected Positive Exposure (EPE) | Time-weighted average of EE | Regulatory capital |
| Peak Exposure | Maximum PFE across time | Stress testing |
Credit Mitigation
| Method | Effect |
|---|
| Netting (ISDA) | Reduces exposure to net across trades |
| Collateral (CSA) | Margin covers positive MTM |
| Central clearing | CCP replaces bilateral exposure |
| Credit derivatives | CDS protection on counterparty |
How It Works in Practice
Monitoring Framework
Daily activities:
| Time | Activity |
|---|
| 8:00 AM | Calculate current exposure by counterparty |
| 9:00 AM | Compare to credit limits |
| 9:30 AM | Review margin call status |
| 10:00 AM | Check for credit rating changes |
| 4:00 PM | Update PFE for significant trades |
Weekly activities:
| Day | Activity |
|---|
| Monday | Full PFE recalculation |
| Tuesday | Credit watchlist review |
| Wednesday | Margin utilization analysis |
| Thursday | Wrong-way risk assessment |
| Friday | Weekly credit report |
Early Warning Indicators
| Indicator | Source | Threshold |
|---|
| CDS spread widening | Market data | +50 bps from baseline |
| Stock price decline | Market data | -20% in 30 days |
| Rating downgrade | Rating agency | Any downgrade |
| Payment delay | Internal records | >1 day late |
| Covenant breach | Borrower disclosure | Any breach |
| Negative news | News services | Material adverse |
Limit Framework
Credit limit structure:
| Limit Type | Purpose |
|---|
| Single counterparty | Maximum exposure to one entity |
| Sector | Aggregate exposure to industry |
| Country | Geographic concentration |
| Rating category | Exposure by credit quality |
| Tenor | Maximum maturity permitted |
Example limits:
| Counterparty Rating | Maximum PFE |
|---|
| AAA/AA | $200 million |
| A | $100 million |
| BBB | $50 million |
| BB | $25 million |
| B and below | Not permitted |
Worked Example
Counterparty Dashboard
Counterparty: ABC Bank (A-rated)
| Metric | Value | Limit | Utilization |
|---|
| Current Exposure | $45M | N/A | — |
| Net Collateral Held | ($40M) | N/A | — |
| Uncollateralized Exposure | $5M | $10M | 50% |
| 1-Year PFE | $85M | $100M | 85% |
| Peak PFE (5Y) | $120M | $100M | 120% |
Alert: Peak PFE exceeds limit
Exposure Calculation
Portfolio with ABC Bank:
| Trade | Type | Notional | MTM | PFE (1Y) |
|---|
| Trade 1 | IRS | $100M | +$12M | $18M |
| Trade 2 | IRS | $50M | +$8M | $12M |
| Trade 3 | XCCY | $75M | +$25M | $35M |
| Trade 4 | CDS | $30M | -$5M | $10M |
| Gross | | | +$40M | $75M |
| Net (with netting) | | | +$40M | $55M |
Collateral impact:
- CSA threshold: $0
- Collateral held: $40M
- Net exposure: $40M - $40M = $0 (current)
- PFE still exists for future moves
Stress Scenario
Scenario: 100 bps rate shock + 50% vol increase
| Trade | Base PFE | Stressed PFE | Change |
|---|
| Trade 1 | $18M | $32M | +78% |
| Trade 2 | $12M | $21M | +75% |
| Trade 3 | $35M | $55M | +57% |
| Trade 4 | $10M | $15M | +50% |
| Total | $55M | $90M | +64% |
Stress utilization: 90% of $100M limit
Risks, Limitations, and Tradeoffs
Model Limitations
| Limitation | Impact |
|---|
| Historical data reliance | May miss unprecedented events |
| Correlation assumptions | Wrong-way risk underestimated |
| Static exposure | Doesn't account for trade changes |
| Collateral assumptions | May not be liquid in stress |
Wrong-Way Risk
Definition: Exposure increases when counterparty credit deteriorates
| Example | Mechanism |
|---|
| Sold put to bank | Bank defaults when market crashes, put ITM |
| Receive fixed from weak credit | Credit deteriorates with falling rates |
| FX swap with EM counterparty | Currency weakens, counterparty under stress |
Monitoring approach:
- Identify wrong-way risk trades
- Apply additional exposure buffer
- Scenario analysis of correlated moves
Concentration Risk
| Type | Measurement |
|---|
| Single name | % of total exposure |
| Sector | Industry classification |
| Geography | Country of domicile |
| Rating | Credit quality distribution |
Example concentration limits:
| Dimension | Maximum |
|---|
| Single counterparty | 15% of total |
| Single sector | 25% of total |
| Single country | 20% of total |
| Below investment grade | 10% of total |
Common Pitfalls
| Pitfall | Description | Prevention |
|---|
| Ignoring net exposure | Using gross instead of net | Apply netting correctly |
| Stale limits | Not updating for credit changes | Review limits quarterly |
| Missing collateral | Not crediting held margin | Daily collateral reconciliation |
| Ignoring PFE | Only tracking current exposure | Monitor both current and potential |
Escalation Procedures
Trigger Levels
| Level | Condition | Action |
|---|
| Watch | 75% limit utilization | Increased monitoring |
| Amber | 90% limit utilization | Trading restricted |
| Red | 100% limit utilization | No new trades |
| Breach | Over limit | Immediate escalation |
Escalation Path
| Level | Notify | Timeframe |
|---|
| Watch | Risk analyst | Daily report |
| Amber | Risk manager | Same day |
| Red | Credit committee | Within 4 hours |
| Breach | Senior management | Immediate |
Remediation Actions
| Action | Purpose | Timeline |
|---|
| Trade unwind | Reduce exposure | Days to weeks |
| Collateral call | Secure current exposure | Same day |
| Novation | Transfer to new counterparty | 1-2 weeks |
| CDS purchase | Hedge credit risk | Same day |
| Trading halt | Prevent further exposure | Immediate |
Reporting
Daily Report Contents
| Section | Content |
|---|
| Top 10 exposures | Largest counterparty exposures |
| Limit utilization | Counterparties near limits |
| Watchlist | Credits under review |
| Margin status | Outstanding margin calls |
| New trades | Impact on exposure |
Monthly Credit Review
| Section | Content |
|---|
| Portfolio overview | Total exposure by category |
| Limit changes | Increases, decreases, new limits |
| Credit events | Defaults, downgrades, upgrades |
| Wrong-way analysis | Correlated exposures |
| Concentration review | Single name and sector |
Checklist and Next Steps
Daily monitoring checklist:
Periodic review checklist:
Related articles: