Volume 4— Credit Risk Management © Copyright 2002, CCRO. All rights reserved. 27 Figure 4. Exposure with Multilateral Netting (Source: Analysis by Tractebel and Strategic Decisions Group) For this analysis, exposures are described in terms of guaranty exposure, which is the credit risk a company imposes on its counterparties. The reason for framing the analysis in this way, as will be seen shortly, is that it allows us to isolate the companies imposing residual credit risk on the industry. Following this definition, the total guaranty exposure must exactly equal the total credit risk. For example, Company C in Figure 3 imposes $37 million of total credit risk on its counterparties. Company A’s credit risk with Company C is $7 million, Company B’s credit risk with Company C is $13 million, and Company D’s credit risk with Company C is $17 million. The total for these three companies is $37 million, which exactly matches what we have called Company C’s guaranty exposure. A comparison of Figure 3 with Figure 4 shows that total credit exposure has been reduced from $172 million to about $21 million, a factor of 8. In Figure 4, Companies A and E become the only credit risks in the market since B, C, and D are all owed money by the market. Figures 5 and 6 incorporate the counterparty VaR numbers, the second number in the brackets, into a simulation to generate the full range of possibilities for the five companies given the initial situation. In Figure 5, the improvement of performance over bilateral netting is illustrated in a probabilistic framework, showing a significant reduction in guaranty exposure over a wide range of scenarios. The worst outcome for multilateral netting still vastly outperforms the best outcome for bilateral netting. Figure 6 illustrates the range of performance probabilistically, which at its worst appears to offer a 75% reduction in credit risk. A + 1 6 .3 B -7 C -2 .5 D -1 1 .4 E + 4 .4 ( 3 ,1 ) ( 7 ,3 ) ( 3 0 ,2 ) ( 4 ,5 ) ( 1 3 ,1 ) ( 8 ,1 ) ( 6 ,0 .7 ) ( 1 7 ,8 ) ( 4 4 ,2 ) ( 3 9 ,4 ) K e y ( $ m illio n s ) ( M T M P o s itio n , 1 D a y V a R ) R e d u c tio n $ 1 7 2 .0 - $ 2 0 .7 = $ 1 5 1 .3 , o r 8 8 % . G u a r a n t y E x p o s u r e ( $ m illio n s ) $ 1 6 .3 -$ 6 .9 -$ 2 .5 -$ 1 1 .4 $ 4 .4 $ 2 0 .7 A B C D E T o ta l G u a r a n t y E x p o s u r e ( $ m illio n s ) $ 1 6 .3 - $ 6 .9 - $ 2 .5 - $ 1 1 .4 $ 4 .4 $ 2 0 .7 A B C D E T o ta l