Dynamic Stress Testing of Counterparty Default Risk

Greg Hopper

Stress testing has become much more widespread following the events surrounding the financial crisis of 2007–9. While much attention has been devoted to the lessons learned in market risk stress testing, comparatively less attention has been focused on counterparty credit risk stress testing. Credit stress testing before the financial crisis had been oriented towards understanding how default risk behaves in a severe economic downturn. While that question is still very important, the financial crisis made clear the importance of understanding how the mark-to-market price of counterparty credit risk changes with extreme market conditions.

The mark-to-market framework in which the price of counterparty risk is calculated is called the credit valuation adjustment (CVA) process. The calculation of CVA allows for the counterparty credit risk of derivatives to not only be marked-to-market but also hedged daily. The daily hedging is a dynamic process in which the amount of the hedges is adjusted for changes in underlying market variables, the credit quality of the hedging bank and the counterparty and the jump-to-default risk of the counterparty. At any point in time, the cumulative