Counterparty Credit Risk: The New Challenge for Global Financial Markets
By Jon Gregory
This week, I am reviewing Counterparty Credit Risk: The New Challenge for Global Financial Markets. This is an ongoing process, so send me your feedback as to how I can provide you with more value in reviewing these books (send me an email here or leave a comment below). See below to learn how you can win this book!
Today’s book is not the kind of book you would read cover-to-cover in a coffee shop with a latte or discuss when you’re having drinks with your friends. But, it is the kind of book that will make you smarter and fill out your financial analysis tool box. And it is the kind of book that I would strongly encourage bankers to read, nay, memorize. Beyond banking, I would recommend this text to anyone whose career, savings, or investment portfolio is subject to the risks and rewards of over the counter derivatives (and let me give you a hint; that probably means you).
First Things First; What is Counterparty Credit Risk and Why Does it Matter?
Since the collapse of multiple high profile financial institutions in the last few years, credit risk management is the new game in town. If banks, funds, and insurance companies didn’t have risk managers (or didn’t listen to them) before, my money is on the fact that they all have robust teams now.
So what is counterparty credit risk? The author describes credit risk as,
“the risk that a counterparty may be unable or unwilling to make a payment or fulfill contractual obligations…the probability of the counterparty defaulting [and] the potential exposure at default and associated recovery value are also important quantities to consider.”
This summarizes the basic fundamentals of analyzing and managing credit risk. Credit risk managers (and active investors like the rest of us) can try to understand the following:
- Probability of Default (requiring an understanding of the counterparty’s credit quality)
- Exposure at Default (requiring an understanding of the value of what is owed)
- Recovery Value (requiring an understanding of what can be claimed)
For the interested non-expert, the first two chapters of the book are a great reference section, with simple yet thorough explanations of the building blocks of credit: ETFs, derivatives, exposure, mark-to-market, netting, collateralization, hedging risk, repos, etc.
Managing Counterparty Credit Risk
The real value in this book is its discussion of how to manage counterparty credit risk. Gregory provides a comprehensive summary of the essential risk management tools and assesses the costs and benefits of such structures along the way. He covers reserve funds, margin placements, centralized clearing, Basel, ISDA, Special Purpose Vehicles, rating agencies, credit insurers and much more.
We know we can’t expect financial institutions to stop trading swaps, leveraging up, and taking large exposures to other financial institutions. What we can expect them to do is manage the risk appropriately, and investors would be wise to research how their companies measure up to the rules, regulations, and guidelines put in place to make our investments safe.
Quantifying and Pricing Counterparty Exposure
In addition to surveying the credit landscape, Gregory included four sections on quantifying and pricing credit risk, seemingly aimed at quants who enjoy formulaic expressions, but fear not, as one of the book’s endorsees wrote, these sections “can be safely skipped.”
As an investor, what can’t be safely skipped is having an understanding of how your investments manage credit risk. With that in mind, Counterparty Credit Risk is definitely a must-have reference book for any investor’s library shelf.
Buy This Book Here or Win This Book!
As I have done with the last few book reviews, I will be using this book as an award for the best investment idea sent to me during the next month. Email me your investment ideas here.
Note: In assessing the quality of your investment idea, I will be looking at how it fits with the investment philosophy I espouse on this site and the strength of the supporting arguments (which can include excel models) as well as the identification of potential pitfalls. I hope that all of those who submit ideas will get some value out of the ensuing discussions. Good Luck!!
No related posts.
to follow a category