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Measuring and marking counterparty risk

The volume of outstanding OTC derivatives has grown exponentially over the past 15 years. Market surveys conducted by the International Swaps and Derivatives Association (ISDA) show notional amounts of outstanding interest rate and currency swaps reaching US$866 billion in 1987, US$17.7 trillion in 1995, and US$99.8 trillion in 2002; an astonishing compounded growth rate of 37.2% per year. Derivatives have expanded the opportunities to transfer risks, allowing for substantially improved risk sharing. They have also created connections among markets and market participants that are only just starting to be understood. Counterparty risk, an example of one such connection, is the risk that a party to an OTC derivatives contract may fail to perform on its contractual obligations, causing losses to the other party. Losses are usually quantified in terms of the replacement cost of the defaulted derivatives and include, beyond mid-market values, the potential market impact of large and/or illiquid positions. Counterparty risks are bilateral – ie, both parties may face exposures depending on the value of the positions they hold against each other. Counterparty risks have mushroomed in the financial markets due to (a) the usual practice of ‘offsetting’ rather than ‘unwinding’ derivative positions and (b) the array of inter-dealer trades required to connect final risk-takers. OTC derivatives and counterparty risks are focal points for market participants, policymakers, regulators, accountants, tax authorities and many others. This chapter is an overview of the key issues relating to the measurement and pricing of counterparty risks.