NOVARUM :: Counterparty Credit Risk

Counterparty Credit Risk

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CCR hedging strategies fall into two broad categories, largely dependent upon the choice of CCR Operating Model.

The Credit Portfolio Model encourages a bifurcated risk practice to align and integrate the risk management of CCR with the loan portfolio management function. Complex mathematical models are employed to disaggregate CCR into its constituent market and credit components. The market component is managed by a dedicated market risk team and the credit component aggregated with more traditional forms of credit risk.

The Self Insured Model encourages a greater variety of hedging strategies primarily focused on creating additional credit capacity to support incremental OTC derivative transactions. Most common amongst these strategies are the “dynamic hedging” of CCR using Credit Default Swaps (“CDS”) and the use of hybrid credit products specifically designed to hedge CCR, such as the Contingent Credit Default Swap (“CCDS”).

In practice, reliable portfolio decomposition under the Credit Portfolio Model has proven extremely complex and computationally onerous. Similarly, effective control and oversight of credit risk mitigation executed under the Self Insured Model has proven problematic given the variety of hedging strategies employed and the range of hedge effectiveness attained.