Credit risk is a significant element of the galaxy of risks facing the
derivatives dealer and the derivatives end-user. There are different grades of
credit risk. The most obvious one is the risk of default. Default means that
the counterparty to which one is exposed will cease to make payments on
obligations into which it has entered because it is unable to make such
payments.
This is the worst case credit event that can take place. An intermediate
credit risk occurs when the counterparty's creditworthiness is downgraded by
the credit agencies causing the value of obligations it has issued to decline
in value. One can see immediately that market risk and credit risk interact in
that the contracts into which we enter with counterparties will fluctuate in
value with changes in market prices, thus affecting the size of our credit
exposure. Note also that we are only exposed to credit risk on contracts in
which we are owed some form of payment. If we owe the counterparty payment and
the counterparty defaults, we are not at risk of losing any future cash flows.
Different aspects of credit risk: market risk, default rates and recovery
rates
The two aspects of credit risk are the market risk of the contracts into
which we have entered with counterparties and the potential for some pejorative
credit event such as default or downgrade.
We know from previous articles on "Risk Measurement" that there
are ways to quantify market risk, including most notably Value-at-Risk
techniques.
The difficult thing is to try and calculate the probability of default or of
a negative credit event. There are different methodologies to try and calculate default risk using the credit spreads observed in
the corporate bond market, historical default rates for a given class of
credit, interpreting information available from financial statements and other
public commentary from the counterparty's management. Check out the
CreditMetrics technical document on the RiskMetrics web site at http://www.riskmetrics.com or
CreditRisk+ at the Credit Suisse First Boston web site. Naturally, these
calculations are complicated by international legal idiosyncrasies.
Another difficulty in assessing credit
risk is estimating the recovery rate. Let's say
that ABC bank defaults and that we have an outstanding swap with ABC, the
market value of which is $10 million in our favor. It is not automatically true
that we are not going to see any of that $10 million once the smoke clears from
the bankruptcy negotiations. We may be able to receive a partial payment. The
recovery rate is the rate at which we are paid in the event of a negative
credit event. If we are paid $2 million at the end of the day, then the
recovery rate here is 20%.
What was the expected value of the swap to us the day before ABC defaulted?
Let's say that we had estimated an ex ante default probability of 5% and a
recovery rate of 20%. Then, the expected value condition is straightforward.
Expected Value Swap=0.95($10 million) + 0.05($10
million x 0.20)=$9.6 million
This expected value of the swap is less than its current market value
because of the possibility of default and less-than-total recovery of the value
of the swap in the event of default.
Calculating credit risk and implications for derivative contracts
There are two steps in calculating credit risk: estimating the credit
exposure and calculating the probability of default. Once we have calculated
these two statistics, we can quantify the credit risk.
The credit exposure is equal to the greater of the current replacement value
of the outstanding contracts plus the expected maximum increase in value of the
contract over the remaining life of the contract for a given confidence
interval or zero. This potential exposure can be calculated using the
Value-at-Risk techniques we discussed in an earlier article. If the sum of the
current replacement value and the potential increase in value of the contract
is negative, then we have no exposure to the counterparty from a credit
perspective because we are obligated to make payments to them.
Credit risk is simply the product of
this calculated credit exposure and the estimated probability of default.
One can see that there are a number of complicating factors implicit in this
calculation of credit risk.
First, as we have noted, it is difficult to measure default
probabilities. Our estimation of the credit risk for a given contract is
limited by the reliability of our default probability forecast.
Second, credit exposure is an increasing function of time because of
the potential increase in value of the contract. The longer a contract's
maturity, the greater the credit risk involved. This is significant for
derivatives, particularly in the case of swaps, because of their long tenor,
typically.
Third, as time passes and the counterparty makes cash flow payments
to us on contracts with a positive value for us, the credit risk of the
contract in terms of potential fluctuations in value is usually reduced. One
example of a case where credit risk is not reduced even as time passes is the
currency swap because of its exchange of principal. The principal exchange risk
outweighs the reduction in credit risk from the payment of cash flows.
Fourth, on structures with amortized payments, it is possible to have
the credit risk "front-loaded" in which most of the cash flows can be
structured to take place early on in the tenor of the swap.
Fifth, when we sell an option to a counterparty, there is no credit
risk from the transaction other than settlement risk. Selling an option obliges
us to make cash flows to the counterparty either by buying or selling the
underlying asset in the case of a put or a call, respectively. However, if the
counterparty exercises a call by buying the underlying asset, they must still
deliver the funds for the stock. This delivery risk is called settlement risk
or Herstatt risk.
Sixth, current positions may not represent future credit risks. That
is why we must include the potential favourable change in value of the swap. A
swap with zero value at inception does not have zero credit risk. It has credit
risk from its potential value in the future.
Credit enhancement and derivatives
Because credit risk is such a tremendous overhang in any relationship, banks
and dealers have worked with lawyers to develop techniques that help mitigate
the credit exposure inherent in derivatives transactions.
First among these techniques is the concept of netting. Netting takes
different forms, depending upon the institutions involved. Imagine DEF Bank and
Flying Boats Incorporated. They have a number of outstanding interest rate swap
contracts on the books, some of which involve cash flows on the same day. DEF
and Flying Boats have a netting agreement in place that compels them to net the
cash flows on any given delivery date into its root payment. For example, if on
July 5, DEF must pay $400,000 to Flying Boats and Flying Boats must pay a total
of $600,000 to DEF, the net payment would be a $200,000 payment from Flying
Boats to DEF.
Second, DEF may ask Flying Boats to put up some collateral against
the market value of the swap. This is the same kind of concept as the margining
that is used on the futures exchanges. Once the market value moves against
Flying Boats past a pre-set threshold, Flying Boats agrees to either top up the
collateral account or to close the contract. This limits the credit exposure.
Third, DEF might ask Flying Boats to put up a third-party guarantee.
In this case, Flying Boats must find some other counterparty that will
guarantee to pay DEF the difference between the market value of the contract
before and after a negative Flying Boats credit event. This is insurance
against the credit risk of the contract that Flying Boats must pay for.
These are just some of the more simple examples of credit enhancement
techniques.
Credit risk is a significant element of any derivatives transaction. Because
of the significance of credit risk, dealers must account for it when they
conduct swaps transactions with their counterparties. This may mean that they
charge a greater swap spread when pricing the swap curve for a particular
counterparty or it may mean that they place greater conditions on the
transaction.
Article by Chand Sooran, Principal Victory
Risk Management Consulting, Inc.
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