In counterparty credit risk management for swaps, forwards, and other derivative contracts, it is recognized that most common applications of credit exposure measurement suffer from the bias that counterparty default is independent of the amount of exposure. Stress tests are often proposed to compensate for this bias, but these measures tend to be arbitrary and cannot be uniformly applied to setting prices and limits as readily as more standardized approaches. The author proposes a framework in which standard measures of counterparty exposure are conditioned on default probabilities. These conditional measures thus account for “rong way” exposures, but fit naturally into current applications.
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