Measuring counterparty risk exposures in the CDS market

13 December 2010

(Extract from page 61 of BIS Quarterly Review, December 2010)

The notional amount of a CDS is the principal amount of debt "insured" by the contract. This is the maximum amount that a seller of protection might have to pay to the buyer. Such an obligation would arise if the entity referenced in the contract defaulted and the recovery rate on its debt was zero. Notional amounts therefore reflect the maximum potential future counterparty exposure of the protection buyer to the protection seller.

The market value of a CDS records the cost of replacing the contract with an equivalent newcontract at current market prices. As such, it provides an indication of current counterparty exposure. Market values are typically much smaller than notional amounts. This is because they reflect the difference between the present values of anticipated future premiums and defaultlinked payments, and the likelihood of default-linked payments is often small.

Neither notional amounts nor market values, however, are comprehensive measures of counterparty risk exposures, as they ignore netting arrangements and collateral. Most outstanding CDS contracts include "closeout netting" provisions, which have proved legally enforceable in the past. This means that current exposures can generally be netted in the event of a counterparty default. Since CDS market participants often hold with the same counterparty some contracts with positive market value and some contracts with negative market value, current counterparty exposures tend to be much lower than gross market values. Gross credit exposures, as reported in the BIS semiannual over-the-counter derivatives statistics, take this into account. They record the sum of market values of all outstanding contracts from the point of view of counterparties with positive market value, after allowing for legally enforceable netting. Credit exposures still overstate current counterparty risk exposures, however, as market participants with positive market value often demand collateral from their counterparties. This would offset losses should the counterparty default.