Understanding credit risk is important for developing a general understanding of derivatives markets and how they are affected by risk.
What is Credit Risk?
There are different grades of this kind of risk. The most obvious one is the risk of default. Default means that the counter-party 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 risk occurs when the counter-party’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 different kinds of risk interact, in that the contracts into which we enter with counter-parties will fluctuate in value with changes in market prices, thus affecting the size of our credit exposure. It is important to note that we are only exposed to risk on contracts in which we are owed some form of payment. If we owe the counter-party payment and the counter-party defaults, we are not at risk of losing any future cash flows.
Credit Risk Characteristics
Different Aspects of Risk
The two aspects of credit risk are the market risk of the contracts into which we have entered with counter-parties and the potential for some negative credit event such as a default or downgrade.
Risk measurement explains 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 used to 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 counter-party’s management.
Another difficulty in assessing risk is estimating the recovery rate. The recovery rate is the rate at which we are paid in the event of a negative credit event.
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 successfully quantify the 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 its remaining life for a given confidence interval, or zero. This potential exposure can be calculated using Value-at-Risk techniques. 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 counter-party from a credit perspective because we are obligated to make payments to them.
One can see that there are a number of complicating factors implicit in this calculation of credit risk.
First, it is difficult to measure default probabilities. Our estimate of the 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 risk involved. This is significant for derivatives, particularly in the case of swaps, because of their typically long lifespan.
Third, as time passes and the counter-party makes cash flow payments to us on contracts with a positive value for us, the risk of the contract in terms of potential fluctuations in value is usually reduced.
Fourth, on structures with amortized payments, it is possible to have the risk “front-loaded.” This means that most of the cash flows can be structured to take place early on in the life of the swap.
Fifth, when we sell an option to a counter-party, there is no risk from the transaction other than settlement risk. The sale obliges us to make cash flows to the counter-party either by buying or selling the underlying asset. However, if the counter-party exercises a call by buying the underlying asset, they must still deliver the funds for the stock.
Sixth, current positions may not represent future risks. That is why we must include the potential favorable change in value of the swap. A swap with zero value at inception does not have zero credit risk. It has risk from its potential value in the future.
Credit Enhancement and Derivatives
Because 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.
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 counter-party 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 risk of the contract that Flying Boats’ must pay for.
These are just some of the more simple examples of credit enhancement techniques.
Significance of Credit Risk
Credit risk is a significant element of any derivatives transactions. Because of the significance of risk, dealers must account for it when they conduct swaps transactions with their counter-parties. It is also an important consideration when buying, selling, or trading derivatives in general.
- Article by Chand Sooran, Point Frederick Capital Management, LLC