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Oxford Analytica analyzes the risks associated with credit default swaps in a new report and warns that counterparty risks could worsen or spread to other markets, such as energy derivatives.

Participants in modern derivatives markets may not have devoted sufficient time, resources and systematic thought to the subtleties of the theory of counterparty credit risk, OxAn says

The concept of ‘wrong-way risk’ is as old as the modern derivatives market. Yet in part because its systemic effects are relatively difficult to model, the threat it poses in particular derivatives transactions — and to the financial system more generally — is often overlooked.

Over the past year, wrong-way risk has chiefly been a problem on credit derivatives markets. However, it could easily worsen, or spread to other markets — such as energy derivatives.

This variety of counterparty risk can be effectively priced and modelled, but this is very time consuming, expensive and often does not fit well with other forms of mathematical risk modelling, OxAn says. The risks associated with wrong-way risk have not been dealt with effectively, and are increasing.

Moreover, the most pernicious type of counterparty risk — the danger that counterparty transaction risk might increase for all counterparties, simultaneously — has become systemic. This threat, known as ‘wrong-way risk’, has become a chronic problem in the developed world.

This situation represents both a failure of risk management modelling and a failure of imagination.

The trouble with credit derivative hedges emerged due to the parlous financial health of some derivative dealers and the monoline insurers that, in effect, act as credit insurers. Dealers and banks are facing the unsettling thought that the credit default swap (CDS) hedges that they had entered into with monolines to help manage risk on their structured credit origination activities will become worthless if these troubled counterparties themselves lurch into bankruptcy.

OxAn says the key to quantifying wrong-way risk is to model correlation between contract values (across a portfolio of derivatives) and counterparty credit quality. The most common generic theoretical approaches include :

  • simulation of counterparty default and exposure jointly;
  • simulation of exposure conditional on counterparty default; and
  • adjusting the expectation of (unconditional) exposure in order to approximate the risk expectation conditional on default.

Significantly, when wrong-way risk is modelled, it is often done via the last approach, due to the fact that it is less computationally expensive and time consuming, and it generates measures of exposure that risk managers find easier to incorporate into their overall risk management framework. However, given the gravity of the crisis, this approach may have been insufficient, OxAn says.

More details are available in the full report, Wrong-way risk’ could exact heavy toll.

Source: Counterparty Risk Could Spread Beyond Credit Markets