CREDIT RISK AND DERIVATIVE PRODUCTS CREDIT RISK AND DERIVATIVE PRODUCTS 
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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