The Effectiveness of Downgrade Provision in Reducing Counterparty Credit Risk

Abstract

TC derivatives market participants are increasingly using downgrade provisions to reduce counterparty credit risk. Such provisions are incorporated, for example, into ISDA master agreement schedules as an “addtional termination event.” The simplest of these provisions allows an entity the right to terminate transactions if its counterparty is downgraded below a certain rating level by a rating agency. Upon termination of a transaction, a payment is exchanged to compensate whichever party is in the money. Alternatively, collateralization schedules might be structured to depend upon rating. For example, an entity rated triple-A might have to collateralize its counterparty’s exposure to it to the extent that exposure exceeds $20 million. A double-A-rated entity might have to collateralize exposure above $10 million. If the collateralization threshold f d s to zero at some rating category, the entity’s counterparty has almost the same practical protection as if it had the right to terminate transactions at that same rating level. Counterparties typically agree to look to the lower of senior-unsecured ratings from Moody’s Investors Service and Standard & Poor’s. 0