8. Counterparty Risk

8. Counterparty Risk

1. Introduction of Counterparty Risk

Counterparty risk is the risk that a counterparty is unable or unwilling to live up to its contractual obligations (i.e., counterparty defaults). Within the context of derivatives contracts, default occurs at some point after inception but prior to the end of the contract term (i.e., presettlement). If default occurs, current and future payments required by the contract will not be made.

• The value of the underlying instrument is uncertain in terms of absolute amount and in terms of which party will have a subsequent gain or loss.
• Counterparty risk is bilateral in that each party takes on the risk that the counterparty will default; the party that is “winning” takes on the risk that the party that is “losing” will default.

Lending risk has two notable characteristics:

• the principal amount at risk is usually known with reasonable certainty (e.g., mortgage at a fixed rate)
• only one party (unilateral) takes on risk.

Counterparty risk is typically used to refer to risk that occurs prior to settlement, which is called presettlement risk.

1.1 Transactions and Institutions

1.1.1 Transacations with counterparty risk

Exchange-traded derivatives do not carry counterparty risk because the exchange is usually the counterparty.

Securities financing transactions include repos and reverse repos, and securities borrowing and lending.

Repos are short-term lending agreements (as short as one day) secured by collateral. The agreement involves a party (the seller or borrower) selling securities to another party (the buyer or lender) for cash, with the seller/borrower buying back the securities at a later date.

Securities borrowing and lending are repos, just with securities involved rather than cash. The associated counterparty risk is similar to that of repos.

OTC derivatives include interest rate swaps (the bulk of the transactions), foreign exchange transactions, and credit default swaps (CDSs).

When comparing an interest rate swap to a regular loan, counterparty risk is reduced for the interest rate swap because there is no exchange of principal. The risk lies in the exchange of floating cash payments versus fixed cash payments. The notion of “netting” further reduces counterparty risk because only the difference between the two payments (the net amount) is exchanged periodically. As soon as the counterparty defaults on payments, there is no need for the other party to continue making payments.

Foreign exchange forwards carry large counterparty risk due to the need to exchange notional amounts and due to long maturities (thereby increasing the probability that a default will occur at least once).

Credit default swaps carry large counterparty risks due to wrong-way risk and
significant volatility (thereby increasing the probability that there will be a losing" party that will default). Wrong-way risk refers to an increase in exposure when counterparty credit quality worsens.

1.1.2 Institutions that take on counterparty risk

Large derivatives players are large banks (dealers) that trade with each other and with a large number of clients.

They tend to have high numbers of OTC derivatives on their books and cover a very wide range of assets, including commodities, equity, foreign exchange, interest rate, and credit derivatives.

They will post collateral against their positions.

Medium derivatives players are often smaller banks or financial institutions that also have a large number of clients and conduct a high volume of OTC derivatives trades.

While they also cover a wide range of assets, they are not as active in all of them as large players.

They will post collateral against positions.

Small derivatives players are sovereign entities, large corporations, or smaller financial institutions with speciic derivatives requirements that determine the trades they undertake.

Trades are done with only a small number of counterparties, and they have few OTC derivatives trades on their books. Unlike large and medium players, small players are likely to specialize in just one asset class.

The collateral will often be illiquid if posted.

1.2 Managing and Mitigating Couterparty Risk

1.2.1 Managing Counterparty Risk

Trading only with high-quality counterparties is a simple and straightforward method for managing counterparty risk. All of these counterparties would have AAA credit ratings and may not be required to provide collateral.

Cross-product netting works with derivative transactions that can have both a positive and a negative value. In the case of a default by either counterparty, a netting agreement will allow transactions to be aggregated and reduce the risk for both parties. The legal and operational risks that accompany netting must be considered. For example, legal risk materializes if a netting agreement is found to be legally unenforceable.

Close-out is the immediate closing of all contracts with the defaulted counterparty. When combined with netting of MtM values, an institution may offset what it owes to the counterparty (a negative amount) against what it is owed by the counterparty (a positive amount). If the net amount is negative, the institution will make a payment, but if the net amount is positive, it will make a claim. This results in an immediate realization of net gains or losses for the institution.

Collateralization (i.e., margining) occurs in the form of a collateral agreement between two counterparties that reduces exposure by requiring sufficient collateral to be posted by either counterparty to support the net exposure between them. Sufficient collateral does theoretically reduce the net exposure to zero. Posting collateral is done on a periodic basis to minimize transaction costs.

A walkaway feature allows a party to cancel the transaction if the counterparty defaults. It is advantageous if a party has a negative MtM and the counterparty defaults.

Diversification of counterparty risk limits credit exposure to any given counterparty consistent with the default probability of the counterparty. When an institution trades with more counterparties, there is much less exposure to the failure of any given counterparty.

1.2.2 Mitigating Counterparty Risk

Netting: Each party’s required payment is computed and then offset so that only the party that “owes” a net amount is required to make that payment to the counterparty. The success of netting depends on the nature of the payments involved and whether they are easy to offset.

Collateralization: Taking collateral equal to or greater than the notional amount of principal should theoretically eliminate all counterparty risk. However, by taking collateral, there are some administrative costs involved in addition to taking on liquidity risk (i.e., collateral may have to be sold at a signiicant discount in the short term) and legal risk (i.e., attempting to take title on the collateral may be a long and drawn out legal process).

Hedging: Using credit derivatives allows an organization to reduce counterparty exposure to its own clients in exchange for increasing counterparty exposure to clients of a competitor. Therefore, hedging generates market risk.

Central counterparties (e.g., exchanges and clearinghouses): They are a convenient way to centralize counterparty risks, settle transactions, and reduce the bilateral risks inherent in many derivatives contracts. However, the use of central counterparties does reduce the incentive of parties to carefully assess and monitor counterparty risks. Therefore, using central counterparties generates operational, liquidity, and systemic risks.

2. Netting, Close-out and Related Aspects

The International Swaps and Derivatives Association (ISDA) Master Agreement standardizes over-the-counter (OTC) agreements to reduce legal uncertainty and mitigate credit risk. This is accomplished by creating a framework that specifies OTC agreement terms and conditions related to collateral, netting, and termination events. The Master Agreement can cover multiple transactions by forming a single legal contract with an indefinite term.

2.1 Netting and Close-out Procedures

2.1.1 Netting and Close-out Between Two Counterparties

Payment Netting, often called set-off, generally refers to combining the cash flows from different contracts with a counterparty into a single net amount, which acts to reduce settlement risk while enhancing operational efficiency.

Not netting

Bilateral netting

Close-out netting, which refers to the netting of contract values with a counterparty in the event of the counterparty’s default.

The concepts of both netting and close-out incorporate two related rights under a single contract:

• the right to offset (net) amounts due at termination into a single sum.
• the right to terminate contracts unilaterally (by only one side) under certain conditions (close-out) .

2.1.2 Netting and Close-out Between Multiple Counterparties

In reality, trades are often structured in a way where an entity trades with multiple counterparties. Under multilateral netting, netting arrangements would involve multiple counterparties to mitigate counterparty and operational risk. Typically, multilateral netting is achieved with a central entity, such as an exchange or clearinghouse, handling the netting process, including valuation, settlement, and collateralization.

An approach for using multilateral netting without the need for a membership organization is trade compression. Because portfolios often have redundancies among trades with multiple counterparties, compression aims to reduce the gross notional amount and the number of trades. Thus, trade compression can reduce net exposure without the need to change an institution’s overall risk profile.

Not netting

Netting(Trade Compression)

Disadvantage:

• The type of netting arrangement mutualizes counterparty risk and results in less incentive for entities to monitor each other’s credit qualities.
• Multilateral netting can enable redundant trading positions to accumulate in the system, resulting in higher operational costs (this risk is reduced by firms that use algorithms to detect and reduce redundant positions).
• Multilateral netting requires trading disclosure, while firms may wish to keep proprietary information confidential.

2.1.3 Advantages and Disadvantages of Netting

Exposure reduction: By offsetting exposures with parties managing net positions only, netting reduces risk and improves operational efficiency. Nevertheless, netted exposures can be volatile, which may result in difficulty in controlling exposure.

Unwinding positions: If an entity wishes to exit a less liquid OTC trade with one counterparty by entering into an offsetting position with another counterparty, the entity will remove market risk; however, it will be exposed to counterparty and operational risk. Netting removes these risks through executing a reverse position with the initial counterparty, removing both market and counterparty risk. The downside is that the initial counterparty, knowing that the entity is looking to exit a trade, may impose less favorable terms for the offsetting transaction.

Multiple positions: An entity can reduce counterparty risk, obtain favorable trade terms, and reduce collateral requirements by trading multiple positions with the same counterparty.

Stability: Without netting, entities trading with insolvent or troubled counterparties would be motivated to cease trading and terminate existing contracts, exacerbating the financial distress of the counterparty. With netting, this risk is significantly reduced, and an agreement with a troubled counterparty is more achievable.

2.2 Termination Features

Termination events allow institutions to terminate a trade before their counterparties become bankrupt.

A reset agreement readjusts parameters for trades that are heavily in the money by resetting the trade to be at the money. Reset dates are typically linked with payment dates, but they could also be triggered after a certain market value is breached.

Additional termination events (ATEs), which are sometimes referred to as break clauses, which allow an institution to terminate a trade if the creditworthiness of their counterparty declines to the point of bankruptcy.

Break clause (also called a liquidity put or early termination option) allows a party to terminate a transaction at specified future dates at its replacement value.

Break clauses are often bilateral, allowing either party to terminate a transaction, and are useful in providing an option to terminate transactions—particularly long-dated trades—without cost when the quality of the counterparty declines.

Events to trigger a break clause generally fall into three categories:

• Mandatory. The transaction will terminate at the date of the break clause.
• Optional. One or both counterparties have the option to terminate the transaction at the pre-specified date.
• Trigger-based. A trigger, like a ratings downgrade, must occur before the break clause may be exercised.

3. Margin(Collateral) and Settlement

3.1 Collateral Management

Collateral is an asset supporting a risk in a legally enforceable way.

Collateral management is often bilateral, where either side to a transaction is required to post or return collateral to the side with the positive exposure.

Firms can manage credit exposures and mitigate counterparty credit risk by either limiting the notional value of trades with counterparties or offsetting trades that limit exposure though netting. There are essentially four motivations for managing collateral:

• reduce credit exposure to enable more trading
• have the ability to trade with a counterparty (e.g., restrictions on credit ratings may preclude an entity from trading on an uncollateralized basis)
• reduce capital requirements
• allow for more competitive pricing of counterparty risk

3.2 Mechanics of Collateral and Types of Collateral

The process of collateralization is typically done through legal documents under which parties negotiate collateral supporting documents that state the terms and conditions of the process.

Collateral agreements should quantify parameters and specify the currency, type of agreement (one-way or two-way), what collateral is eligible, timing regarding delivery and margin call frequency, and interest rates for cash collateral.

Trades between counterparties are then marked-to-market (MtM) on an ongoing basis (typically daily), and valuations including netting are determined. The party with the negative MtM exposure then delivers collateral to the other side of the transaction, and the collateral position is updated.

Collateral can include cash, government and government agency securities, mortgage-backed securities, corporate bonds and commercial paper, letters of credit, and equity.

The most common type of collateral is cash; however, during extreme market events, the supply of cash collateral can be limited.

Other collateral types, including agency securities, are often preferred for liquidity; however, recent market events have led to questioning the true riskiness of these securities. In addition, noncash collateral may give rise to problems with rehypothecation (defined later) and create price uncertainty.

3.3 Valuation Agent

Valuation agent is responsible for calling for the delivery of collateral and handles all calculations.

The valuation agent’s role is to calculate

• credit exposure
• market values
• credit support amounts
• the delivery or return of collateral.

Larger entities often insist on being valuation agents when dealing with smaller counterparties.

When the size difference between counterparties is small, both counterparties may be valuation agents. In this case, each entity would call for collateral when they have positive exposure; however, this could lead to disputes and delays in processing collateral movements.

One remedy is to use a third-party valuation agent that would handle the collateral process, processing collateral substitutions, resolving disputes, and producing daily valuation reports.

3.4 Collateral Agreements

3.4.1 Types of CSA Agreements

No CSA
Institutions may be unable or unwilling to post collateral.

This may be because their credit quality is far superior to their counterparty or they cannot commit to the operational and liquidity requirements that arise from committing to a CSA.

Two-way CSA
When two counterparties are relatively similar, as it will be beneficial to both parties involved.

The two sides may not be treated equally, as certain key parameters (like threshold and initial margin) may differ depending on the respective risk levels of each party.

One-way CSA
Only one counterparty need to post collateral (either immediately or after a specific event, such as a ratings downgrade). It is established when two counterparties are significantly different in size, risk levels, et cetera.

The CSA will be beneficial to the receiver of the collateral and at the same time will present additional risk for the counterparty posting the collateral.

3.4.2 Collateral Agreement Features

Collateral agreements are typically negotiated prior to any trading, and they are often updated prior to an increase in trading. Parameters must be clearly defined, and parties must balance the work involved in calling and returning collateral with the benefits of risk mitigation.

Threshold
Threshold refers to the level of exposure below which collateral will not be called. As a result, threshold represents the level of uncollateralized exposure, and only the incremental amount above the threshold would be collateralized.

Thresholds generally aim to reduce the operational burden of calling collateral too frequently. A threshold of zero means any exposure is collateralized, while a threshold of infinity means all exposure is uncollateralized.

Lower credit ratings correspond to lower or zero threshold amounts.

Initial margin
Initial margin is the collateral amount that is posted upfront and is “independent” of any subsequent collateralization. It is used to mitigate the widening of credit spreads or declines in equity values.

Initial margin is required by stronger credit quality counterparties or by the counterparty more likely to have positive exposures and represents a level of overcollateralization.

The level of initial margin increases with lower ratings.

Initial margins can be thought of as converting counterparty risk into gap risk. It should be large enough to minimize the gap from large value movements of trades should the risky counterparty default.

Minimum transfer amount
A minimum transfer amount represents the smallest amount of collateral that can be transferred. A minimum transfer amount is used to reduce the operational workload of frequent transfers for small amounts of collateral, which must be balanced against the beneits of risk mitigation.

The threshold and minimum transfer amount are additive. Exposure must exceed the sum of both before a collateral call can be made.

Higher credit ratings corresponds to higher amounts.

Rounding
Collateral amounts use rounding (e.g., to the nearest thousand) to avoid transferring very small amounts during collateral calls or returns.

Haricut
A haircut is a discount to the value of posted collateral. In other words, a haircut of $x\%$ means that for every unit of collateral posted, only $1-x\%$ of credit will be given. This credit is also referred to as valuation percentage.

Cash typically has a haircut of $0\%$ and a valuation of $100\%$, while riskier securities have higher haircut percentages and lower corresponding valuation percentages.

3.4.3 CSA Calculations

ISDA documentation specifies that the credit support amount is equal to the amount of the requested margin. This amount will not be equal to the value of the portfolio due to parameters such as thresholds, initial margins, and minimum transfer amounts.

Credit support balance($\text{CSB}$) means the margin held previously.

Scenario 1

	Time 1	Time 2	Time 3
Portfolio Value / V	90	110	150
Threshold	0
Minimum Transfer Amount / MTA	50
Credit Support Balance / CSB	0	90	90
Credit Support Amount / CSA	90	0	60

Time 1: $V_1-{\text{CSB}}_1=90>\text{MTA}=50\to {\text{CSA}}_1=90,{\text{CSB}}_2=90$

Time 2: $V_2-{\text{CSB}}_2=30<\text{MTA}=50\to {\text{CSA}}_2=0,{\text{CSB}}_3=90$

Time 2: $V_3-{\text{CSB}}_3=60>\text{MTA}=50\to {\text{CSA}}_3=60$

Scenario 2

3.4.4 Collateral Agreement Risks

Collateral agreements could potentially cause the following risks.

Market Risk
Market risk relates to the degree of market movements that have occurred since the last posting of collateral. It is relatively small compared to the risk of an uncollateralized situation, but market risk is a challenge to hedge and to quantify.

Even though collateral is in place to mitigate counterparty risk, there will always be some residual risk due to parameters such as minimum transfer amounts and thresholds that delay the collateral process. In addition, even when collateral is called, there will be a normal delay in sending/receiving the collateral. This delay is represented as the margin period of risk, which is the effective time between a collateral call and the receipt of the collateral.

Operational Risk
Potential pitfalls in the handling of collateral include missed collateral calls, failed deliveries, computer error, human error, and fraud. Proper controls must be in place to reduce the likelihood of the occurrence of any one of the foregoing items. Examples of proper controls would be the existence of accurate and enforceable legal agreements, robust IT systems capable of automating many steps in the process, timely and accurate valuation of the collateral, current information on initial margins, minimum transfer amounts, rounding, a requirement that collateral types and currencies must be available for each counterparty, and careful observation of the failure to deliver collateral.

Liquidity and Liquidation Risk
Transaction costs may result when having to liquidate collateral to mitigate counterparty risk. These are often in the form of a bid-ask spread or selling costs. Liquidating a security in an amount that is large relative to its typical trading volume may negatively impact its price, leading to a substantial loss. The alternative is to liquidate a position slowly. With this approach, the counterparty is exposed to market volatility during the period of liquidation.

Funding Liquidity Risk
Funding liquidity risk refers to the ability of an institution to settle its obligations quickly when they become due, which results from the funding needs established in a CSA. For various reasons, collateral agreements are not in place for many OTC derivatives transactions. When a counterparty does not have the operational capacity or liquidity to handle frequent collateral calls (required under a CSA), the counterparty will be vulnerable to funding implications. This risk is relatively small when markets are liquid and funding costs are low. However, when markets are illiquid, the risks become higher because funding costs can increase considerably.

Default Risk
The default of a security posted as collateral will lower its value (when the loss in value is unlikely to be covered by a haircut). Cash or high-quality fixed-income securities are usually the preferred type of collateral. Should the collateral’s credit rating fall below what the collateral agreement speciies, then it would need to be replaced. Poor collateral may fail to mitigate counterparty risk.

Foreign Exchange Risk
Foreign exchange risk occurs when counterparties have different currencies. Collateral carrying foreign exchange risk can be hedged in spot and forward markets. The process must be done carefully due to the dynamic and changing value of the collateral.

4. Future Value and Exposure

4.1 Credit Exposure Metrics

Expected mark to market (MtM) is the expected value of a transaction at a given point in the future. Long measurement periods as well as the specifics of cash lows may cause large differences between current MtM and expected MtM.

Expected exposure (EE) is the amount that is expected to be lost if there is positive MtM and the counterparty defaults. Expected exposure is larger than expected MtM because the latter considers both positive and negative MtM values.

Potential future exposure (PFE) is an estimate of MtM value at a specific point in the future. It is usually based on a high confidence level, taking into account the worst-case scenario. The current MtM may follow a number of different possible paths into the future, so a probability distribution of PFE can be derived, similar to the one shown in the following picture. Positive MtM in the shaded area is the part of the exposure that is at risk. Any points in this shaded area can represent PFE.

In other words, PFE is the worst exposure that could occur at a given time in the future at a given confidence level. Potential future exposure represents a “gain” amount because it is the amount at risk if the counterparty defaults. Maximum PFE is the highest PFE value over a stated time frame.

Expected positive exposure (EPE) is the average EE through time. Expected positive exposure is a useful single amount to quantify exposure.

Negative exposure, which is the exposure from the counterparty’s point of view, is represented by negative future values. The expected negative exposure (ENE) is the exact opposite of EPE.

The effective EE and effective EPE measures are meant to properly capture rollover risk for short-term transactions (under one year). Effective EE is equal to nondecreasing EE. Effective EPE is the average of the effective EE.

4.2 Credit Exposure Factors

The credit exposure proile is impacted by several factors, including:

Future uncertainty
In situations where there is a single payout at the end of the life of a contract, uncertainty regarding the value of the final exchange increases over time.

Foreign exchange forwards and FRAs often have single payouts at the end of their contract lives.

Periodic cash flows
Unlike the situation where there is a single payout, when cash lows occur regularly, the negative impact of the future uncertainty factor is reduced.

However, additional risk exists when periodic cash lows are not equal in each period and are based on variables that may change as is often the case in an interest rate swap with variable interest rates.

Combination of profiles
This exists when the credit exposure of a product results from the combination of multiple underlying risk factors.

A cross-currency swap (which combines a foreign exchange forward trade with an interest rate swap) is a good example of this factor.

Optionality
Exercise decisions (e.g., a swap-settled interest rate swaption) will have an impact on credit exposure.

4.3 Security Exposure Profiles

PFE is a measure of counterparty and credit risk exposures. Thus, the maximum credit risk exposure indicated by a PFE analysis is the upper bound on a confidence interval for future credit risk exposure.

Bonds and loans
The PFE of bonds, loans, and repos are approximately equal to the notional value.

Bonds typically pay a fixed interest rate. If interest rates decline, then the exposure may increase.

Loans typically have variable interest rates, and the exposure over time may decrease as a result of prepayments.

Interest rate swaps
Exposure profiles of interest rate swaps are typically characterized by a peak shape. This peaked shape results from the balancing of future uncertainties over payments and the roll-off risk of swap payments over time.

Cross-currency swaps
Cross-currency swaps exposure is a combination of an interest rate swap and an FX forward transaction.

The high volatility of FX rates, long maturities, and large final payments of notional value result in monotonically increasing exposures for foreign exchange products.

The majority of the exposure of interest rate risk results from the uncertainty regarding the final notional value payment associated with FX rate risk.

Options
The following picture provides an exposure profile for a long option position (with up-front premium) and illustrates the increase over time of the exposure until the option is exercised. The exact shape of the graph can change when the option is near, in, or out of the money. However, the increase over time is similar for all options due to the fact that the option can be deep in the money.

4.4 Comparing Credit Exposure to VaR Methods

Value at risk ($\text{VaR}$) is a measure used to estimate the risk of loss on a portfolio of financial/investment assets (e.g., stocks, bonds, derivatives, etc.).

The characterization of credit exposure is similar to the characterization of $\text{VaR}$, although additional considerations are relevant to credit exposure, described as follows:

Application
Credit exposure is deined for both pricing and risk management, whereas $\text{VaR}$ is just for risk management. As a result, quantifying credit exposure is more dificult and may result in different calculations for both pricing and risk management purposes.

Time horizon
$\text{VaR}$ models are based on a relatively short time horizon, whereas credit exposure must be defined over many time horizons.

The trend (i.e., drift) of market variables, their underlying volatility, and their levels of co-dependence become relevant for credit exposure, whereas for $\text{VaR}$, these elements are irrelevant due to the short time horizon.

Also, while $\text{VaR}$ tends to ignore future contractual payments and changes such as exercise decisions, cash lows, and cancellations, credit exposure must take these elements into account because they tend to create path dependency (i.e., credit exposure in the future depends on an event occurring in the past).

Risk mitigants
Netting and collateral are examples of risk mitigants, designed to reduce the level of credit exposure. In order to estimate future levels of credit exposure, these mitigants need to be taken into account. Netting requires that the proper rules be applied, which may add a level of complexity. Future collateral adds a signiicant element of subjectivity, as the type of collateral and time to receive collateral must all be modeled even though they may be unknown.

5. Credit Value Adjustment(CVA)

5.1 Calculation of CVA

The credit value adjustment(CVA) is defined as the expected value or price of counterparty credit risk and it is the difference between risk-fee value and the true value.

$$\text{CVA}=\text{Risk-free Value}-\text{True Value/Risky Value}$$

5.1.1 Standard Estimation of CVA

Assuming independence between $\text{PD}$, exposure and recovert(ignoring wrong-way risk), the simplified $\text{CVA}$ expression is given by:

$$\text{CVA}=\text{LGD}\sum _{i=1}^m{\text{EPE}}_{t_i}{\text{PD}}_{t_{i-1},t_i}$$

• Assuming no wrong-way risk.
• $\text{LGD}$ is loss given default or how much of the exposure one expects to lose in the event of a counterparty default; equal to $1$ minus the recovery rate ($1-\text{RR}$
• $\text{EPE}$ is discounted expected positive exposure for future dates
• $\text{PD}$ is marginal default probability
  

5.1.2 Estimating CVA as a Spread

Suppose that instead of computing the $\text{CVA}$ as a stand-alone value, we want to express it as a running spread (per annum charge).

$$\text{CVA}=\text{average EPE}\times \text{Spread}$$

Assumptions for this calculation include:

• $\text{EPE}$ is constant over the entire profile
• Default probability is constant over the entire profile
• $\text{EE}$ or default probability is symmetric over the entire profile.

5.1.3 Impacts on $\text{CVA}$

Credit Spread
The $\text{CVA}$ will most often increase given an increase in the credit spread. However, the impact will not be linear because default probabilities are limited to 100%.

If a counterparty is very close to default, the $\text{CVA}$ will actually decrease slightly, and in default the $\text{CVA}$ will fall to zero.

When considering the shape of the credit spread curve,

• the $\text{CVA}$ will be lower for an upward-sloping curve compared to a flat and a downward-sloping curve
• the $\text{CVA}$ will be higher for a downward-sloping curve compared to a flat and an upward-sloping curve.

Recovery Rate
Increasing the recovery rate will reduce the resulting $\text{CVA}$.

Differences in settled versus actual recovery rates may also be considered. The settled recovery is the recovery at default, while the actual recovery is the claim amount that will be received.

As an example, consider a settled recovery rate of 10% and an actual recovery rate of 40%. In this situation, the higher actual recovery rate will produce a lower $\text{CVA}$ compared to a 40% recovery assumption for both settled and actual recovery rates.

Margin

Collateralization reduces the $\text{CVA}$, changing only the counterparty’s expected exposure ($\text{EE}$), but not its default probability.

Inclusion of minimum transfer and threshold amounts would correspondingly increase the $\text{CVA}$ as they increase exposure linearly.

An increase in initial margin, which is a negative threshold amount, would decrease the $\text{CVA}$.

The margin period of risk ($\text{MPoR}$) defines the number of calendar days over which the $\text{CVA}$ is measured. As $\text{MPoR}$ increases, the $\text{CVA}$ will gradually move toward the uncollateralized CVA.

At an MPoR of 40 days, the $\text{CVA}$ is about half the size of the uncollateralized $\text{CVA}$. Once the $\text{CVA}$ for a speciic date is known, it can be scaled by using the square root of time rule. For example, compared to the 10-day $\text{MPoR}$, the approximation for the $\text{CVA}$ of 20 calendar days would be $1.41$ times larger (i.e., bigger negative).

5.2 Incremental and Marginal CVA

5.3 CVA for a Bilateral Contract