1. THE PROFESSIONAL RISK MANAGERS’
INTERNATIONAL ASSOCIATION
PRMIA CREDIT and COUNTERPARTY
RISK MANAGER HANDBOO K

2. PRMIA Credit and Counterparty Risk
Manager Handbook
Edited by
Justin McCarthy and Stefan Loesch

3. Copyright © 2015 Professional Risk Managers’ International Association 3
Copyrighted Materials
Copyright © 2015 by The Professional Risk Managers’ International Association. All rights
reserved.
Published by PRMIA Publications, Wilmington, DE
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This book is also available in an electronic format, on-line via the PRMIA website and may be
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ISBN: 978-0-9963394-6-9
Printed in the United States of America

4. Copyright © 2015 Professional Risk Managers’ International Association 5
About the Authors
Justin McCarthy has worked in roles in many firms, including Bank of America Merrill Lynch,
PricewaterhouseCoopers and with the Irish Financial Regulator. This work has allowed him to
see the changes in risk management since through and beyond the recent global financial crisis.
His work with the Irish Regulator on the PRISM risk-based supervision framework included
exposure to banking, funds, and insurance risk practices, as well as the quantitative work done
on the related impact models.
He serves on several PRMIA working groups and sits on the PRMIA Education Committee and is
the chair of the C-Suite Committee. He is also the chair of the global board for PRMIA.
His work includes training and consulting with financial institutions on governance, risk
management, and compliance. This has included writing and delivering courses on risk
management in Irish Academic institutions. Justin has a BSc from University College Cork and an
MBA from the Michael Smurfit Graduate School of Business at University College Dublin.
Stefan Loesch is a rocket scientist by training who went on to work as a derivatives quant in the
financial services industry, where he ended up heading the FX and equities quant research
teams of Paribas.
After earning an MBA at INSEAD, he joined McKinsey & Co. as a consultant in their pan-
European Corporate Finance Practice, where he was advising clients in the financial services
sector. He then moved to J.P.Morgan where he was initially a member and eventually the
leader of a strategic advisory team working with banks on capital markets-driven balance sheet
optimization, integrating solutions using DCM, ECM, securitization, and derivatives.
Now Stefan is running Oditorium, a startup that is developing systems and tools for online
executive education, and that is also organizing executive training in the finance and risk space,
usually integrating online and classroom teaching.
Markus Krebsz is Chief Risk Officer and Seasoned Risk Specialist with more than 20 years
experience in global financial markets, with 15 of those years in Risk.
Markus is a member of several United Nations Economic Commission for Europe risk
management groups and previously acted as Credit rating expert advisor to the World Bank and
the European Commission.
A prolific author and editor of a number of risk-related books, Markus is a well-regarded
thought-leader and lecturer with some of the world’s best academic institutions.

5. Copyright © 2015 Professional Risk Managers’ International Association 6
Robert McWilliam has over 25 years of Front Office and Risk Management expertise at major
international banks. He has set up CVA desks and has first-hand experience of pricing and
hedging derivative counterparty risks (CVA, DVA, and Wrong-Way risk), Funding and Capital.
This experience included structuring and selling a €7bn securitization of derivative counterparty
credit exposures.
He made his first collateral call in 1995 and went on to build and run a collateral management
desk for a major dealer. From 1998 to 2004 he chaired the ISDA Collateral Committee and was
a member of the European Commission’s Collateral Forum group that led to the EU Collateral
Directive.
Mr. McWilliam is an Advisory Board member for Imperial College Business School’s Finance
MSc Programs and is co-Regional Director of the London chapter of PRMIA, the Professional
Risk Managemers’ International Association.
Varun James Sehgal has been working in the financial services industry for over 18 years across
3 continents and gained a diverse set of experiences in Market Risk, Credit Risk and Portfolio
Management. James has in-depth experience in North American, European and Asia Pacific
markets, including their respective products and risks. Over the past 10 years, he has worked
exclusively on CVA, Funding, Capital & Collateral both in London, U.K. and Asia Pacific.
His last major senior role was Asia Pacific Head of the CVA/XVA Portfolio Management located
in Singapore for the Royal Bank of Scotland. He undertook this role for more than 5 years and
built up the desk and team from ground zero. Over this period, he and his team made
significant achievements in optimizing the regional CVA portfolio, reducing capital constraints
and reducing counterparty exposure. Prior to that, he was based in London, working for ABN
Amro as part of their CVA desk where he worked as part of a team to build the technology
platform and portfolio manage and trade the global CVA portfolio.
Before relocating back to the United Kingdom, James was located in North America where he
initiated his career in the financial industry. Prior to working in banking, James worked in the
medical field, specifically doing research in Cardiology where he received an achievement
award from the International Society of Nuclear Medicine.
At present, he is located in Singapore, where he has been senior consultant for risk in clearing
of derivatives and counterparty exposure.
James graduated from the University of Toronto with a MA in Economics and an Honours BA
degree in Economics and Biochemistry & Microbiology.

6. Copyright © 2015 Professional Risk Managers’ International Association 7
Recognitions
Grateful acknowledgment is made to the following PRMIA Volunteers for their contribution to
this Handbook:
PRMIA Education Committee for its oversight of the entire PRM Handbook Curriculum and
PRM Exam syllabus.
Members (listed alphabetically): James V. Dillon, Jonathan Howitt (Chair), James Glueck, Justin
McCarthy, Oscar McCarthy, Kalyan Sunderam, Stefan Loesch, Scott Warner. Ex Officio: Andy
Condurache, Kevin Cuff and Alex Voicu.
Monika Smatralova for her contribution as author to the Classic Credit Products and Classic
Credit Lifecycle chapters.
Andy Condurache, PRMIA Director of Exams and Publications, for the production editing of this
book.
Disclaimer
The views and opinions expressed in this publication are those of the authors and do not
necessarily reflect the views or positions of any of the organizations to which they belong.

7. Copyright © 2015 Professional Risk Managers’ International Association 9
Table of Contents
Copyrighted Materials............................................................................................................. 3
About the Authors................................................................................................................... 5
Part 1 – Credit Risk ................................................................................................................ 13
Chapter 1 – Classic Credit Products .................................................................................................... 15
Important Credit Instruments.....................................................................................................................15
Building Blocks ............................................................................................................................................16
Instruments.................................................................................................................................................30
Chapter 2 - Classic Credit Life Cycle .................................................................................................... 49
Justin McCarthy...........................................................................................................................................49
Introduction to Credit Risk and Credit Risk Basics......................................................................................49
Origination Phase........................................................................................................................................53
Credit Risk Assessment ...............................................................................................................................55
Monitoring Phase........................................................................................................................................60
Workout Phase............................................................................................................................................62
Other Considerations..................................................................................................................................66
Chapter 3 - Classic Credit Risk Methodology....................................................................................... 69
Markus Krebsz.............................................................................................................................................69
Introduction And Setting The Scene ...........................................................................................................69
Fundamental Credit Analysis ......................................................................................................................71
Analysing Wholesale Credit ........................................................................................................................87
Analysing Retail Credit ..............................................................................................................................102
Conclusion: Classic Vs. Modern Credit Analysis Methodologies ..............................................................114
Chapter 4 - Credit Derivatives And Securitization ............................................................................. 117
Structured Credit As A Funding Tool.........................................................................................................118
Linear Credit Risk Transfer........................................................................................................................132
Structured Credit As A Risk Management Tool ........................................................................................138
Bespoke Structured Credit........................................................................................................................157
Chapter 5 - Modern Credit Risk Modeling......................................................................................... 165
Stefan Loesch............................................................................................................................................165
Credit Risk Parameters..............................................................................................................................165
Credit VaR Models ....................................................................................................................................174
Implementation ........................................................................................................................................192
Modelling Credit Risk Mitigation ..............................................................................................................202
Risk Allocation and Performance Management .......................................................................................204
Chapter 6 - Credit Portfolio Management ........................................................................................ 211
Stefan Loesch............................................................................................................................................211
CPM Goals and Philosophy .......................................................................................................................211
CPM Instruments ......................................................................................................................................212
CPM Analytics ...........................................................................................................................................215
CPM In Practice.........................................................................................................................................227
Part 2 – Counterparty Risk................................................................................................... 237
Chapter 7 - Basics of Counterparty Risk............................................................................................ 239

8. Copyright © 2015 Professional Risk Managers’ International Association 10
Historical Perspective................................................................................................................................239
The OTC Derivative Market.......................................................................................................................244
Exposure Measurement............................................................................................................................246
Risk Appetite.............................................................................................................................................250
Chapter 8 - Risk Mitigation............................................................................................................... 253
Documentation .........................................................................................................................................253
Netting ......................................................................................................................................................255
Collateral...................................................................................................................................................257
Clearing .....................................................................................................................................................261
Compression .............................................................................................................................................262
Chapter 9 - Credit Valuation Adjustment, CVA ................................................................................. 267
CVA Definition and Calculating CVA..........................................................................................................267
Debit Valuation Adjustment, DVA ............................................................................................................279
Wrong-Way Risk........................................................................................................................................283
Organizational Challenge..........................................................................................................................285
Chapter 10 - CVA-related Aspects – Toward XVA.............................................................................. 287
Funding Valuation Adjustment, FVA.........................................................................................................287
Capital .......................................................................................................................................................295
Leverage Ratio ..........................................................................................................................................299
Liquidity Ratios..........................................................................................................................................301
Chapter 11 - Managing Counterparty Risk and CVA.......................................................................... 303
Hedging CVA..............................................................................................................................................304
Central Clearing Counterparties (CCP)......................................................................................................307
Managing Distressed Names and Defaults ...............................................................................................311

9. Copyright © 2015 Professional Risk Managers’ International Association 13
Part 1 – Credit Risk
Authors: Stefan Loesch, Justin McCarthy and Markus Krebsz
with contributions from Monika Smatralova

10. Copyright © 2015 Professional Risk Managers’ International Association 15
Chapter 1 – Classic Credit Products
Stefan Loesch
Important Credit Instruments
Generic Fixed Income Instruments
In a fixed income instrument, the lender advances funds to a borrower (usually the ‘principal’
and often also the ‘notional’ amount, see below), who in turn promises to return those funds
over time, usually together with some interest payments. Those instruments are called fixed
income instruments on the basis that their payments are known in advance, as opposed to
those under an equity instrument that generally transfers a portion of the risk and rewards of a
project or an enterprise, and where future payments are uncertain.
The term fixed in fixed income has to be taken with a grain of salt since it technically applies
only to loans where the interest rate has been fixed in advance, and where there is no variation
on the amount or timing of the principal to be returned. Variable interest loans are very
common – for example, with the interest on the loan linked to a published rate such as LIBOR.
Variable principal loans are less common, with one exception: very often the borrower has an
option to prepay the loan. However, other variable principle “structured” loans exist, where, for
example, the principal is indexed to inflation. We will discuss structured loans in more detail
below.
The outline of this section is as follows:
First, we describe low-level building blocks of fixed income instruments, but with
numerous references to actual instruments used
Then, we describe some mid-level building blocks that effectively join those building
blocks together, again with reference to actual instruments used
Finally, we provide detailed information on the most important fixed instruments
themselves, and how they relate to the building blocks
There is a certain amount of circularity and duplication in the way the topic is being presented
here, as we are trying to optimize the presentation for a reader who has some understanding of
the topic already, but whose understanding is not necessarily very deep. Some readers –
especially those who are not familiar with the topic – might benefit from reading the section
twice because knowledge of some of the later sections might help in understanding the earlier
sections more easily. Unfortunately, there is no easy way around presenting highly
interconnected material without boring more advanced readers with endless repetition and
cross references.