Restructuring Counterparty Credit Risk

TL;DR

This paper develops a comprehensive theoretical framework for modeling derivative transactions between defaultable entities, extending traditional CVA/DVA approaches and exploring ten different structuring styles including CCP clearing.

Contribution

It introduces a novel arbitrage-free framework that categorizes and compares ten derivative structuring styles based on default contingency handling.

Findings

Ten structuring styles identified and characterized

Comparison of styles on risk, complexity, and economic impact

Framework extends traditional CVA/DVA models

Abstract

We introduce an innovative theoretical framework to model derivative transactions between defaultable entities based on the principle of arbitrage freedom. Our framework extends the traditional formulations based on Credit and Debit Valuation Adjustments (CVA and DVA). Depending on how the default contingency is accounted for, we list a total of ten different structuring styles. These include bipartite structures between a bank and a counterparty, tri-partite structures with one margin lender in addition, quadri-partite structures with two margin lenders and, most importantly, configurations where all derivative transactions are cleared through a Central Counterparty (CCP). We compare the various structuring styles under a number of criteria including consistency from an accounting standpoint, counterparty risk hedgeability, numerical complexity, transaction portability upon default, induced behaviour and macro-economic impact of the implied wealth allocation.