Counterparty risk subject to additional termination event clauses

Richard Zhou

Abstract

ABSTRACT

The credit additional termination event (ATE) clause is a counterparty risk mitigant that allows banks to terminate and close out bilateral derivative contracts if the credit rating of the counterparty falls below the trigger level. Since credit default is often preceded by rating downgrade, credit ATE can significantly reduce the counterparty credit risk by preemptively terminating the counterparty exposure. However, there is still the risk that the counterparty may default without going through a severe downgrade. This paper presents a highly practical method for valuating bilateral credit value adjustment in the presence of an ATE trigger.