Being two-faced over counterparty credit risk

A recent trend in quantifying counterparty credit risk for over-the-counter derivatives has involved taking into account the bilateral nature of the risk so that an institution would consider their counterparty risk to be reduced in line with their own default probability. This can cause a derivatives portfolio with counterparty risk to be more valuable than the equivalent risk-free positions. In this article, Jon Gregory discusses the bilateral pricing of counterparty risk and presents an approach that accounts for default of both parties. He derives pricing formulas and then argues that the full implications of pricing bilateral counterparty risk must be carefully considered before it is naively applied for risk quantification and pricing purposes

Counterparty credit risk is the risk that a counterparty in a financial contract will default prior to the expiry of the contract and fail to make future payments. Counterparty risk is taken by each party in an over-the-counter derivatives contract and is present in all asset classes, including interest rates, foreign exchange, equity derivatives, commodities and credit derivatives. Given the recent decline in credit quality and heterogeneous concentration of credit exposure, the high-profile