A Post Lehman Approach To Counterparty Risk

The stunning reversal in the Lehman matter of the long held belief that it is the non-defaulting counterparty that "determines in good faith" the replacement value of OTC derivatives, will require a re-think of counterparty credit risk exposure.

Traditionally, counterparty risk has been viewed as current exposure by less sophisticated counterparties and as current exposure plus potential future exposure (pfe) by more sophisticated counterparties. Yet the Lehman framework brings into question the definition of current exposure. Most counterparties view current exposure as their mtm less collateral held/posted. But if their mark is substantially different than that of their counterparties, and their counterparty defaults and is allowed to impose their mark, then they could have greater exposure than they think.

Unless the "unusual" approach adopted by the court in the Lehman Brothers matter is reversed/clarified, we recommend that counterparty risk for otc derivatives be measured as;

1. MTM
   Plus
2. Collateral dispute amount
   Plus
3. 3 to 10 days VAR (or more) to reflect the likely unwind period
   Plus
4. Potential Future Exposure (PFE)
   Minus
5. Collateral