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P2.T6.900. Counterparty risk and xVA (Gregory Ch.4)

Nicole Seaman

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Learning objectives: Describe counterparty risk and differentiate it from lending risk. Describe transactions that carry counterparty risk and explain how counterparty risk can arise in each transaction. Identify and describe institutions that take on significant counterparty risk.


900.1. Julia the analyst is analyzing the credit risk of a contract to which her firm is considering entering into as a party. If true, which feature of her work (among the choices below) most likely signifies or indicates that this is a case of counterparty credit risk rather than (traditional) lending risk or some other type of risk?

a. Her analysis requires quantifying the Herstatt risk
b. The exposure at default (EAD) is 100% of the notional over most of the life of the contract
c. Her firm is the only party assuming credit risk: if her firm defaults, the other party faces no losses
d. She is employing Monte Carlo simulation because the future value of the contract is highly uncertain

900.2. Acme Financial Incorporated has an outstanding derivatives contract with its counterparty. Currently, neither posts collateral, but they mutually agree to a modification such that the revised contract now includes a bilateral collateral arrangement. Which risk has Acme reduced?

a. Acme reduced counterparty risk
b. Acme reduced operational risk
c. Acme reduced market/liquidity risk
d. All of the above (reduction in counterparty, operational, and market/liquidity risk)

900.3. Which of the following statements about counterparty risk is TRUE?

a. When properly defined and parameterized, market risk variables should not influence the ultimate counterparty risk metric
b. If a bank runs a flat (i.e., hedged) book with almost no MTM volatility or market risk, then by design it must also be hedged with respect to counterparty risk
c. Because reduction in one xVA component may create/increase another xVA component, it is critical to manage xVA centrally; xVA refers value adjustments associated with credit, debt, funding, collateral, margin, capital and liquidity
d. The un- or under-collateralised OTC market is not an important source of counterparty risk because it occupies less than 8.0% of the derivatives market: it is only 20% of the bilateral OTC market, which in turn (compared to centrally-cleared OTC) is only 40% of the OTC market, which in turn (compared to exchange-traded) is 91% of the derivatives market.

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