This review is from: Counterparty Credit Risk: The new challenge for global financial markets (The Wiley Finance Series) (Hardcover)

A common issue in banks with a derivative franchise is that business people (such as credit, sales and senior management) have to make decisions about credit risk using information produced by quants without fully understanding what they are looking at. Quants & business types have different ways of looking at the world & aren’t always good at communicating with each other: hence business people tend to see outputs from models as a `black box’. This fault line moved in scary fashion during the Credit Crisis like so many others in the industry (`what do you mean the exposure is twice what the model predicted? What do you mean it wasn’t a prediction? What is it for then?’).

What is needed is a book which gives equal weight to all aspects of counterparty credit risk, the practical and the computational, and explains the latter in a clear way. This book aims to do this: the blurb describes it as `practically focused’ and `designed for any market practitioner with any responsibility in any area of counterparty credit risk’. Gregory is a quant, and he is much better at describing the quantificational issues than most of his peers. However, whilst there is much good stuff in here for those with a quant background, I think other users will struggle with this, and may also find it too heavily weighted towards the computational rather than the practical (although a useful feature is that a lot of the formulae are consigned to appendices at the end of each chapter). Also the balance between cover of Credit Derivatives and other products doesn’t seem right.

There is some good stuff about practical risk management in here but apart from the relatively brief chapter `Mitigating Counterparty Risk’ it is dotted around the book rather than be addressed systematically. The market is introduced, and the basics of risk management and measurement for the majority of products rushed through in 3 chapters and 125 out of 400 pages. For a book to comprehensively cover counterparty credit risk as is claimed, then in my opinion there should be more thorough, sequential treatment of :-

* The different risk profiles over time of forwards, swaps & options;

* The dynamics driving the risk profiles of the major products over their maturity (FX, Interest Rates, etc). Most products are dismissed in a couple of paragraphs, whereas there is a separate chapter on Credit Derivatives;

* Warning signals of increased risk and toxic trades (e.g. lending risk, payment frequencies, out of the money barriers). There is a lot of coverage of wrong way risk in this context, but again from the angle of quantifying it and largely in relation to Credit Derivatives rather than managing the risk in practice for all products;

* All the available mitigation techniques and their good & bad points;

* Practical credit issues arising from ISDA documentation.

Having said all this, there is a lot to recommend the book for those with some familiarity with the product and who are interested in the technicalities of the computation of risk. In particular this book gives the clearest description of I have seen of the issues around the calculation & hedging of the `Credit Valuation Allowance’ (CVA). Most transactions a bank enters into, such as a loan or a derivative trade, involve credit risk, and this risk has to be priced, and covered out of earnings. This is formally known as the `expected loss’, and CVA is the expected loss on a derivative trade; alternatively, it can be seen as the price of counterparty credit risk. Banks should price this risk into the spread they charge their customers, & hedge this risk dynamically using index and single name Credit Default Swaps (CDS). Gregory describes clearly the different risk parameters & the basics of how this is done.

He deals particularly well with the thorny issue of bilateral CVA (BCVA): how can 2 institutions (e.g. 2 dealer banks) both charge each other for CVA simultaneously? How can they therefore come up with a price at which to trade with each other? Firms will calculate BCVA for this purpose, but it means an institution is attaching value to its own default, which is counterintuitive (we are trying to manage our credit risk here!). As Gregory points out, if 2 counterparties find it difficult to trade with each other as they both wish to charge positive CVA, there are 2 possible solutions: (1). price using BCVA (so 1 party net pays the other) or (2) both parties take account of their risk to each other & mitigate as strongly as possible, e.g. through netting and collateral. I agree with his conclusion that (1) might work a quick fix but (2) is ultimately more appropriate.

There are useful chapters on central counterparties and regulatory capital for counterparty credit risk, although unfortunately the book was published before the controversial Basel III proposals were published, so these issues are not discussed.

One mistake I noticed is where Gregory states that central counterparties remove credit risk (page 14): `when trading a futures contract the actual counterparty is the exchange': this is only true for exchange members facing other exchange members (at least once the trade is matched and given up). A party which is not a member of the exchange and the clearing house has to trade through an exchange member who will `carry’ the trade for them, and will have an exposure to the counterparty in a similar way to an OTC trade (although exchange rules on segregation may mitigate this exposure to some extent). There are also plenty of typos but that seems normal for a 1st edition of any book these days- proofing by spell checker, probably.

In the end I was undecided about whether I should rate this at 3 or 4 stars. In the end I opted for 4 because there is lots of useful stuff here, although it should arguably be a 3 as it should be better organised, & doesn’t really do what it says on the tin

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