Counterparty risk exposures: Capturing

credit correlation between counterparty and underlying

Kirk Buckley*, Sascha Wilkens** and Vladimir Chorniy***

Version: 15 April 2010

Abstract. This paper presents a semi-analytical approach for calculating the counterparty
exposure of credit derivative contracts conditional on the default of the counterparty, based
on a Merton-type asset return model. The approach provides an efficient algorithm for
implementing large-scale exposure calculations for portfolios of credit derivatives.

JEL classification: G13; G15.

Keywords: derivatives; credit; correlation; counterparty risk.

* BNP Paribas, Fixed Income CVA Trading, London. E-Mail:

Kirk.Buckley@bnpparibas.com.
** BNP Paribas, Market and Counterparty Risk Analytics, London.
E-Mail: Sascha.Wilkens@bnpparibas.com. Corresponding author. Address: BNP Paribas,
Group Risk Management, 10 Harewood Avenue, London NW1 6AA, United Kingdom.
*** BNP Paribas, Market and Counterparty Risk Analytics, London.
E-Mail: Vladimir.Chorniy@bnpparibas.com.

We appreciate helpful discussions with Lee Moran. The views expressed in this paper are those of
the authors and do not necessarily reflect the views and policies of BNP Paribas.

Electronic copy available at: http://ssrn.com/abstract=1590482

Introduction

The conventional approach to the calculation of counterparty exposure assumes that

the underlying of the derivative contract and the counterparty credit quality are
uncorrelated. There are many cases, however, where this assumption does not
necessarily hold. Examples of these cases include emerging market currencies,
commodity producers hedging future production and credit derivative contracts. In
the following paper, we focus on the case of credit derivatives where the reference
entities are correlated with the credit quality of the counterparty.

The recent credit crisis has demonstrated that it is important to capture this
correlation when calculating the counterparty risk associated with credit derivatives
(European Central Bank (2009)). The most common risk measures are the exposure
at a given percentile and the expected exposure profile, which is used for credit
valuation adjustment (CVA) and regulatory capital calculations. The regulatory
framework on internal models for counterparty risk (confer Basel Committee on
Banking Supervision (2006)) lacks a clear guidance on how to deal with
counterparty-asset correlation in particular, although wrong-way risk is one of the
key areas on which regulators focus; capturing a counterparty-asset dependency can
therefore be seen at least as an implicit requirement. Irrespective of external rules,
financial institutions have a genuine interest in detecting and measuring
counterparty-asset correlation for the purpose of prudent risk management.

Established approaches to modeling credit risk correlation among firms mainly

comprise structural Merton-type and reduced-form models. In spite of a rich
literature on credit correlation, including the subclass of default contagion models,
only a few papers concentrate on counterparty risk measures. Hull/White (2001),
Kim/Kim (2001), Walker (2006), Brigo/Chourdakis (2008) and Leung/Kwok (2009),
for example, value credit derivatives taking counterparty default risk into account.
Leung/Kwok (2005) consider default correlation between protection buyer, protection
seller and reference entity in credit default swaps. Brigo/Pallavicini (2008) study
counterparty risk in the case of correlation between interest rates and credit.

Electronic copy available at: http://ssrn.com/abstract=1590482

Introduction

The conventional approach to the calculation of counterparty exposure assumes that

the underlying of the derivative contract and the counterparty credit quality are
uncorrelated. There are many cases, however, where this assumption does not
necessarily hold. Examples of these cases include emerging market currencies,
commodity producers hedging future production and credit derivative contracts. In
the following paper, we focus on the case of credit derivatives where the reference
entities are correlated with the credit quality of the counterparty.

The recent credit crisis has demonstrated that it is important to capture this
correlation when calculating the counterparty risk associated with credit derivatives
(European Central Bank (2009)). The most common risk measures are the exposure
at a given percentile and the expected exposure profile, which is used for credit
valuation adjustment (CVA) and regulatory capital calculations. The regulatory
framework on internal models for counterparty risk (confer Basel Committee on
Banking Supervision (2006)) lacks a clear guidance on how to deal with
counterparty-asset correlation in particular, although wrong-way risk is one of the
key areas on which regulators focus; capturing a counterparty-asset dependency can
therefore be seen at least as an implicit requirement. Irrespective of external rules,
financial institutions have a genuine interest in detecting and measuring
counterparty-asset correlation for the purpose of prudent risk management.

Established approaches to modeling credit risk correlation among firms mainly

comprise structural Merton-type and reduced-form models. In spite of a rich
literature on credit correlation, including the subclass of default contagion models,
only a few papers concentrate on counterparty risk measures. Hull/White (2001),
Kim/Kim (2001), Walker (2006), Brigo/Chourdakis (2008) and Leung/Kwok (2009),
for example, value credit derivatives taking counterparty default risk into account.
Leung/Kwok (2005) consider default correlation between protection buyer, protection
seller and reference entity in credit default swaps. Brigo/Pallavicini (2008) study
counterparty risk in the case of correlation between interest rates and credit.

1
Within the class of Merton-type credit derivatives simulation models that are usually
the first choice from a modelling perspective due to their straightforward
implementation and calibration, there are various ways to incorporate counterparty
correlation into the exposure of a portfolio conditional on default of the counterparty.
The first approach involves a full correlated simulation of both the counterparty and
underlying(s) of credit derivatives. At each time step, only those paths where the
counterparty has defaulted are used to calculate the exposure distribution. This
approach has the obvious disadvantage of being computationally intensive as a large
number of simulation paths must be generated in order to have a sufficient sample to
calculate the various counterparty risk measures at a given confidence level. The
alternative approach involves applying an approximation in order to incorporate the
default conditionality into the model. The latter, which broadly follows and extends
ideas in Hille et al. (2005) and Van Boxtel (2007), is considered in this paper:
Transforming the unconditional exposure distribution into the conditional exposure
distribution through a one-step approximation has the advantage of simplicity in that
it does not require any significant additional computational time compared with
conventional exposure model simulations. The approach is therefore easily scalable
to counterparty risk modelling in a bank-wide portfolio.1

Model setup

The focus of the modelling is the exposure at default in the case of correlation
between the reference entity and the deal counterparty. Following a Merton-like
technique for each underlying, the simulation of rating transitions and defaults is
accomplished by simulating a standard normal variable at each time step (for each
underlying, as a combination of systematic and idiosyncratic factors) and then

1 For purposes of counterparty risk modelling and management of credit derivatives, the
exposure at default for a large number of counterparties (> 1,000), with a very large
total number of trades (> 100,000), at a set of future time points (typically more than
100), about the expected value and at high confidence levels (typically between 90%
and 99%), in an uncollateralised or collateralised setting needs to be projected in at
least daily batch runs. Intraday simulations for limit checks and CVA calculations
prior to entering new trades are additional requirements.

2
comparing this to a threshold that reflects the probability
to migrate from rating (as simulated for the previous time point ) to a new
rating over the time interval . This approach relies on the assumption
that the rating transition has the following properties:2
• Markov property: At any time the probability of transition to another state at
time only depends on the current state of the process.

• Time homogeneity: The transition probabilities only depend on the time

interval over which the transition takes place.

The actual calculation of the thresholds can be accomplished in a number of ways

but is usually done through the definition of a generator matrix (see Israel et
al. (2001) for methods and issues), which defines the transition matrix for arbitrary
times:

, (1)
where the exponential of a matrix is defined through Taylor series expansion.

If a two-asset system is considered, with one asset defined as the counterparty and
the other as the underlying, the correlated asset returns at time can be expressed as
follows:

(2)

where and are independent standard Gaussian deviates. As the exposure is

conditional on default, all of the scenarios for the asset must be calculated
conditional on , where is the threshold
to go from the initial counterparty rating to default at time . The distribution
of asset returns conditional on default of the counterparty can be characterised by:

(3)
and

2 These assumptions are implicitly made through the calibration of the migration
thresholds for all time points using only a single historical transition matrix as input.

3
 (4)

with and as the cumulative standard

normal distribution function. The mean and variance of the distribution of
conditional on therefore read as follows:

(5)

which reduces to the appropriate limits of mean 0 and variance 1 as . These

expressions can be used to transform the unconditional distribution of asset returns
with mean 0 and variance 1 to a conditional distribution with mean and variance
. This provides a straightforward way of incorporating counterparty correlation
into the asset simulations:

. (6)
This expression does not modify the correlation between two different assets.
Figure 1 illustrates the effect of conditioning the reference entity’s rating
distributions on the counterparty default. At a one-year horizon, typical
transformations of the asset return distribution conditional on default of a well-rated
hedge fund, a major financial institution and a G-10 country are shown. Notably,
higher moments of the conditional asset return distributions are of minor importance,
rendering the approximation by means of the first two moments very accurate for
practical purposes.

[Insert Figure 1 here]

The actual simulation steps can be summarised as follows:

1. Simulate unconditional asset returns to time step which are then converted to a
rating .3

3 In case the default state is reached the subsequent transformations are not necessary,
assuming a non-negative correlation between the asset returns of the counterparty and
the reference entity.

4
2. Transform the rating into an approximate asset return using the thresholds
as defined from time 0 to time for an initial rating . The
mapping is approximate since the equivalent asset return is anywhere between
and .4

3. Apply the transformation from unconditional to conditional asset returns using

and that are defined according to the counterparty rating and
simulation time . For each time , the thresholds can be calculated using the
probability of default associated with the counterparty rating.

4. Convert the conditional asset return back to a conditional rating

using the thresholds up to time , .

Table 1 provides the example of the rating evolution over time for a BBB-rated
reference entity (Panel A), based on the 90th percentile of the rating distribution. For
a one-year ahead projection, for instance, the unconditional rating of the underlying
amounts to BBB-, equivalent to a one-notch downgrade. In the case of a financial
institution defaulting at this time horizon, however, the assumed rating of a BBB-
reference entity would have deteriorated by additional eight notches to CCC at the
90th percentile.

[Insert Table 1 here]

4 As a simple approach, the equivalent asset return can be defined as the midpoint.
A more sophisticated technique would be to set the equivalent asset return to the
expectation conditional on being between and
. Alternatively, a random number can be drawn from a distribution
with mean and variance conditional on the barriers and
.

5
Transforming ratings into spread and exposure distributions

In order to transform the rating simulations into actual potential future exposure
profiles conditional on the default of the counterparty, a credit spread simulation
process such as5

(7)
can be employed for each rating band, where is the mean-reversion speed, stands
for the long-term mean of the spread and is the volatility.6 Such a spread process
possesses several desirable properties like mean reversion, an analytic solution and
positive spread simulation paths. The overall spread path can then be assumed to
follow the rating-band-specific process and exhibit asset value-driven jumps in case
of rating transitions that follow the economic rating.7

Typical values for spreads and CDS exposures over time at the 90th percentile are
shown in Table 1 (Panels B and C). At a one-year horizon, for example, the credit
spread of a BBB-rated underlying would have doubled at the 90th percentile, while –
conditional on the default of a major financial institution – it would have quadrupled.
The effect on the value of a CDS on the reference entity is obtained easily from the
spread distribution.

Notably, the (unilateral) CVA follows directly from the model output:

, (8)

where is the recovery rate of the counterparty, denotes the probability of its
default between times and , stands for the (risk-free) discount factor at
time and is the expected exposure conditional on the
counterparty defaulting at time between and .

5 See, for example, Schönbucher (2003) for typical credit spread processes.
6 Note that is an adjustment such that the spread process converges to the long-term
mean at large simulation time .
7 The model can be easily enriched by market event-driven jumps in the spread process.

6
Calibration

One obvious limitation of the one-factor model setup is the strict functional
relationship defining the conditionality influence and the stress parameters to be
applied to the first and second moments of the unconditional asset return distribution.
In general, counterparty correlation in the above definition is meant to account for
longer term correlation in firms’ asset values. For example, if an AA-rated entity
defaults in two years it is likely that the overall economic conditions have led to a
significant deterioration in economy-wide asset values, thus increasing the default
probability of other entities. In the short term, however, the default of a (well-rated)
counterparty is likely to have a low correlation with the development of overall asset
values and is therefore more idiosyncratic in nature.

The model should hence be extended to reflect a term structure of counterparty

correlation. For the longer-term counterparty correlation, a recent study by
Zhang et al. (2008) analysing default-implied asset correlations suggests that these
should be in the region of 10% through 30%. Using a parameterised correlation as a
function of time,8 however, will usually not allow enough flexibility; furthermore, in
this case the implication on the transformation of the asset return distribution is not
easily tractable and might cause inconsistencies with the underlying asset pricing
model. A more flexible and more transparent way of incorporating counterparty
conditionality consists in a direct specification of the stress parameters and .
Providing these as time-dependent functions for each possible combination of initial
ratings of counterparty ( ) and asset ( ) and potentially each simulation
time step (i.e., potential default time , as well as for ) allows a high degree of
flexibility. The empirical calibration of the conditionality in general lacks sufficient
historical observations, because of the small sample of actual defaults (e.g., Lehman
Brothers). One assumption that could be made is that implied correlations of equity

8 For example, with as

configurable parameters.

7
tranches provide an indication of the asset correlation level, although this is rather
the market expectation of correlation levels used for pricing purposes.

In order to allow for more granularity in the correlation structure among different
assets, the one-factor asset model can be extended. The systematic asset return can be
driven, for example, by country-specific and industry-specific factors as well as
global factors. This implicitly defines the asset correlation structure between the
names. The application of such a more granular correlation approach between
underlyings is straightforward. For consistency reasons, the conditionality stress to
be imposed for a given counterparty could have dimensions such as region/country
and industry as well. However, the balance between computational speed and
complexity is quickly reversed as the “dimensionality” of the parameterisation
increases.

Critical discussion and practical implications

The conditioning of exposures on the counterparty default implies that larger haircuts
or margins are to be applied for better-rated counterparties, in accordance with the
anticipated degree of market distress in case of their default. This is rather
counterintuitive and not in accordance with market practice. Since exposures are
derived conditional on default of the counterparty, backtesting them against actual
realisations is usually not possible, with the few exceptions of actual realised
counterparty defaults. Therefore, a separate calculation of unconditional exposure
profiles is useful to monitor the model behaviour over time.

One simplification of the discussed approach is the single-step conditioning on

default. If the exposure of a credit derivative is dependent on the spread path, for
example, in the case of a physically settled CDS option, the one-step conditionality
stress does not provide the path that led to the counterparty defaulting. This is similar
in the case of calculating exposures for collateralised counterparties, which usually
requires knowledge of the collateral amount held at the last margin call date prior
to default at time . In case of daily margin calls the path dependency of
conditionality is quite weak (assuming a small Minimum Transfer Amount); for

8
larger margin call periods the collateral held at conditional on default at time
will approach the unconditional value. As a practical solution to reflect the path
dependency, the conditional and unconditional PV in each time point and simulation
universe can be calculated and incorporated into the exposure, for example, by
means of interpolation.

Summary and future research

This paper presents an easy-to-implement solution to account for dependency bet-

ween counterparty and reference entity in counterparty credit exposure calculations.
Due to the semi-analytic nature of the approach simulation run times even for large
portfolios are not significantly impacted compared to unconditional exposure
projections. As outlined, certain challenges such as the parameterisation of the
conditionality impact and the treatment of path-dependent derivatives and collateral,
do remain.

Against the tendency to move credit derivatives contracts to central counterparties

and clearing houses, one might critically question whether a default conditionality
approach as researched so far is still applicable; this would require default and
correlation information for such counterparties, for example, the default of which
would be considered a catastrophe scenario.

The discussed approach is, in principal, applicable to all kinds of credit derivatives as
well as to instruments from other asset classes. Recently, Brigo/Pallavicini (2008)
presented an extension of the counterparty-underlying dependency concept to
interest-rate instruments. A further development of the approach discussed here to
equity derivatives could be a next step – a similar, but likely weaker effect on
exposures would be expected. In the context of calculating bilateral CVA (confer
Gregory (2009)), the incorporation of an institution’s own probability of default into
the conditionality modelling could be studied as well (see, for example, Leung/Kwok
(2005), for a potential model framework).

9
References
Basel Committee on Banking Supervision (2006), Basel II: International Convergence of
Capital Measurement and Capital Standards: A Revised Framework – Comprehensive
Version, June 2006.
Brigo, Damiano; Chourdakis, Kyriakos (2008), Counterparty Risk for Credit Default Swaps.
Impact of Spread Volatility and Default Correlation, Working Paper, Fitch Solutions,
Version: October 2008, forthcoming in: International Journal of Theoretical and
Applied Finance.
Brigo, Damiano; Pallavicini, Andrea (2008), Counterparty Risk and CCDSs under
Correlation, Risk, Vol. 21, February, pp. 84-88.
European Central Bank (2009), Credit Default Swaps and Counterparty Risk, Report,
August 2009.
Gregory, Jon (2009), Being Two-faced Over Counterparty Credit Risk, Risk, Vol. 22,
February, pp. 86-90.
Hille, Christian; Ring, John; Shimamoto, Hideki (2005), Modelling Counterparty Credit
Exposure for Credit Default Swaps, Risk, Vol. 18, May, pp. 65-69.
Hull, John; White, Alan (2001), Valuing Credit Default Swaps II: Modeling Default
Correlations, The Journal of Derivatives, Vol. 8, Spring, pp. 12-22.
Israel, Robert B.; Rosenthal, Jeffrey S.; Wei, Jason Z. (2001), Finding Generators for
Markov Chains via Empirical Transition Matrices, with Application to Credit Ratings,
Mathematical Finance, Vol. 11, pp. 245-265.
Kim, Mi Ae; Kim, Tong Suk (2001), Credit Default Swap Valuation with Counterparty
Default Risk and Market Risk, The Journal of Risk, Vol. 6, No. 2, pp. 49-80.
Leung, Kwai Sun; Kwok, Yue Kuen (2005), Credit Default Swap Valuation with
Counterparty Risk, Kyoto Economic Review, Vol. 74, June, pp. 25-45.
Leung, Kwai Sun; Kwok, Yue Kuen (2009), Counterparty Risk for Credit Default Swaps:
Markov Chain Interacting Intensities Model with Stochastic Intensity, Working Paper,
Chinese University of Hong Kong, Version: June 2009.
Schönbucher, Philipp J. (2003), Credit Derivatives Pricing Models, Chichester.
Van Boxtel, E.G. (2007), Modelling Credit Rating Dynamics Conditional on Counterparty
Default, Master's Thesis, Tilburg University, Amsterdam.
Walker, Michael B. (2006), Credit Default Swaps with Counterparty Risk: A Calibrated
Markov Model, Journal of Credit Risk, Vol. 2, No. 1, pp. 31-49.
Zhang, Jing; Zhu, Fanlin; Lee, Joseph (2008), Asset Correlation, Realized Default
Correlation, and Portfolio Credit Risk. Modeling Methodology, Report, Moody's
KMV, March 2008.

10
 Tab. 1:
Impact of counterparty default conditionality on rating, spread and
exposure distributions over time for a BBB-rated reference entity

Time (years) Unconditional CP: Well-rated CP: Major financial CP: G-10 country
hedge fund institution

A. 90 percentile of the conditional rating distribution (S&P rating scale)

0.0 BBB BBB BBB BBB

0.5 BBB BB+ BB- B+
1.0 BBB- BB- CCC CCC
1.5 BBB- B+ CCC CCC
2.0 BB+ B+ CCC D
2.5 BB+ B D D
3.0 BB B D D

B. 90 percentile of the conditional credit spread distribution* (bps)

0.0 200 200 200 200

0.5 378 459 628 705
1.0 408 566 829 916
1.5 412 566 776 917
2.0 396 572 783 873
2.5 377 551 752 846
3.0 367 514 722 807

C. 90 percentile of the conditional uncollateralised exposure of a 5-year long CDS contract**

(% of notional)

0.0 0.0 0.0 0.0 0.0

0.5 7.8 10.9 16.8 19.8
1.0 8.1 13.4 22.3 25.8
1.5 6.9 12.2 17.8 23.0
2.0 5.9 10.2 15.6 20.9
2.5 4.8 8.2 12.8 15.5
3.0 3.6 6.3 10.0 12.1

CP: Counterparty.

* The credit spreads are obtained only from those simulation paths where the underlying has not defaulted up to that
point in time.
** Assumed recovery rate: 30%.
 0.45

0.40

0.35

0.30

0.25

0.20

0.15

0.10

0.05

0.00
-5.0 -4.0 -3.0 -2.0 -1.0 0.0 1.0 2.0 3.0 4.0 5.0

Unconditional CP: Well-rated hedge fund

CP: Major financial institution CP: G-10 country

CP: Counterparty.

Fig. 1: Approximated conditional asset return distribution depending on counterparty credit

quality (one-year horizon)