Counterparty Risk & XVA

Walk onto any derivatives desk and you will hear a question that never comes up when you buy a stock or a bond on an exchange: what happens if the person on the other side of this trade doesn’t pay? When you sign a five-year swap, you are not just taking a view on rates — you are entering a multi-year credit relationship with whoever sold it to you. They might go bust while the swap is worth a fortune to you. Worse, you might go bust while it is worth a fortune to them. Counterparty credit risk is the risk that the other party to a derivative defaults before settling what they owe — and unlike a loan, the amount they owe can swing from zero to enormous and back again as markets move.

This is the expert capstone of the risk track. You already know how to build a swap from its legs, value it off a curve, and price the credit risk of a bond or a CDS. Here you put all of it together to answer the question a real risk officer, an XVA desk, or a clearing-house treasurer is paid to answer: given everything I trade with this counterparty, how much could I lose if they fail, how do I shrink that, and what should I charge for what remains?

• What counterparty risk is — why a derivative is a two-way credit exposure that a loan is not, the difference between settlement and replacement risk, and how 2008 turned a footnote into a front-office discipline.
• Measuring exposure — current exposure, expected exposure (EE) and its average EPE, and potential future exposure (PFE); the diffusion-vs-amortisation tug-of-war that gives a swap its hump-shaped profile and an FX forward its rising one.
• Netting & collateral — how close-out netting collapses a whole book to a single number, and how a CSA with variation margin, initial margin, thresholds, minimum transfer amounts and haircuts crushes the exposure that is left.
• CVA — the price of default — the credit valuation adjustment as the market price of counterparty risk, its three ingredients (exposure × default probability × loss given default), and the mirror-image DVA on your own credit.
• The XVA family — the post-2008 alphabet soup: FVA (funding), MVA (initial-margin funding), KVA (capital) and ColVA, assembled into the waterfall that turns a risk-free price into the price a desk actually charges.
• Wrong-way risk & clearing — when exposure and default probability rise together (and the right-way case where they offset), and the great post-crisis migration to central counterparties, their default waterfalls, and the SA-CCR capital rules and uncleared-margin plumbing that govern the rest.

By the end you’ll measure a counterparty’s exposure profile, knock it down with netting and a CSA, price the CVA/DVA on what survives, walk the full XVA waterfall from risk-free to all-in, spot wrong-way risk before it bites, and explain exactly how central clearing reshapes — but never quite removes — the cost of who you trade with.