Saturday, August 21, 2010

Three Measures of Counterparty Risk

What does an increase in counterparty risk even mean? It means that banks become more reluctant to lend to other banks because of the perception that the risk of default on their loans has increased and/or the market price of taking on such risk has risen. The following three measures are said to reflect the current amount of counterparty risk.

Libor-Ois spread:

Overnight index swap (OIS) is composed As follows: at maturity, the parties exchange the difference between the interest that would be accrued from repeatedly rolling over an investment in the overnight market and the interest that would be accrued at the agreed OIS fixed rate. In contrast to Libor loans, OIS transactions involve little counterparty risk as no money changes hands until the maturity date. The difference in these two spreads is said to reflect counterparty risk and not liquidity factors.

Credit Default Swaps:
One measure of counterparty risk is the probability that banks might default on their debt. These probabilities can be assessed using the premiums on credit default swaps (CDS) which are like insurance policies for corporate bonds. the purchaser of a CDS pays a periodic fee to the seller in exchange for the promise of a payment, in the event of a bankruptcy or a default, of the difference between the par value and the market value of the corporate bond.

Libor-Repo spread:
This is the interest rate spread between unsecured and secured lending. The greater the risk of nonpayment of the loan the higher the spread should be. Repurchase Agreements(Repos) between banks are backed by Treasury Securities and are a form of secured lending.

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