NOVARUM :: Counterparty Credit Risk

Counterparty Credit Risk

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Increasingly, counterparty credit risk managers are turning to the CCDS market to hedge CCR given the ease with which the CCDS can be fully integrated into the underlying computation of CCR. A CCDS is a variation of CDS where the notional amount is defined as the replacement cost of a hypothetical Reference Derivative, determined upon an event of default by the Reference Credit, subject to a minimum value of zero.

The CCDS notional amount mimics the CCR to the Reference Credit created by the Reference Derivative. Accordingly, the CCDS Reference Derivative can be introduced as a simple “contra netting set” in the derivation of expected and maximum positive exposure profiles and EPE, where the CCDS Reference Credit and underlying OTC derivative counterparty are the same legal entity.

To enhance liquidity and price transparency in the CCDS market, many dealers have developed simple optimization programs to derive portfolios of “plain vanilla” CCDS contracts to hedge even the most complex OTC derivative netting sets.

The CCDS eliminates the need to bifurcate CCR into its constituent market and credit components, eliminating the principal drawback of the Credit Portfolio Model. Furthermore, the establishment of a market standard CCDS template under the auspices of ISDA significantly simplifies the control and governance of CCR hedging under the Self Insured Model.

The ease of inclusion of the CCDS in the underlying derivation of CCR offers counterparty credit risk managers the ability to simultaneously address internal credit constraints, mitigate potential CVA volatility, and reduce counterparty RWAs through the application of a single standardized hedging instrument.