Impact of Systemically Important Counterparty Default on Counterparty Credit Risk

In general, Counterparty Credit Risk (CCR) in Over-the-Counter (OTC) derivatives has been significantly mitigated by margin regulations. Specifically, Initial Margin (IM) is expected to cover the increment of the exposure during Margin Period of Risk (MPoR) from a counterparty default to the actual liquidation. Since this incremental exposure is treated as a random variable at the time of the last margin delivery, IM is calculated in practice using a unified simplified calculation method called ISDA Standard Initial Margin Model (ISDA SIMM). However, it is generally known that a default of a large financial institution, which is defined as a "Systemically Important Counterparty (SIC)" by Pykhtin and Sokol (Risknet, 26(9), 88–93 2013), impacts financial markets, thereby increasing CCR exposure. ISDA SIMM attempts to incorporate such events in simplified conservative methods, nevertheless it does not accurately model the systemic impact. In this study, we derive analytical approximate formulas for key CCR indicators that directly incorporate the impact of a SIC default as a discrete jump, thereby avoiding the need for computationally intensive stochastic simulations. Furthermore, we conduct numerical experiments across several jump scenarios, using a European swaption under the SABR model as a case study. The results suggest that, depending on the transaction type and the nature of the jump, IM may not satisfy the regulatory requirements under the impact. Consequently, our findings imply that it is crucial for measurement and management of CCR to accurately model the impact of a SIC default.