LINK OF COUNTERPARTIES VIA CREDIT EXPOSURES
As illustrated in Figure 9.5, the lender and borrower are linked throughout an exposure of a certain value, e.g., loan, where they agree on exchanging cash flows. Moreover, a guarantor and/or protection seller is linked to the investor by covering any potential losses of the outstanding credit exposures; they are also linked to the obligor in that their protection is against counterparty risk.
Therefore, the credit exposures impact directly and/or indirectly the
FIGURE 9.5 Evolution of credit exposures based on several scenarios
linkage and correlation among counterparties. We can say that a credit event in an exposure may impact several counterparties. The link we describe here is slightly different from the correlation via market sectors discussed previously in Chapter 7. Sector correlation describes a link by association to a group or locale, whereas the link via credit exposure has to do with co-dependency related to contractual cash flows exchanges and/or exposure value changes. We call the latter wrong-way risk, where the exposure increases when the credit quality of the counterparty declines. The International Swaps and Derivatives Association (ISDA) defines wrong-way risk as the risk that occurs when exposure to a counterparty adversely correlates with the credit quality of that same counterparty. Wrong-way risk, often called wrong-way exposure,4 is discussed in Chapter 10.
As we will discuss in Chapter 11, minimizing concentration and systemic risk in regards to the exposures implies a significant reduction of the expected credit losses in case that single or minimum number of credit events may rise. Notably, the identification of the links and correlations among counterparties based on the concentration and systemic exposure analysis can be the basis of analyzing the interdependency of P2P counterparties.
9.7