Outline how credit risk exposure arises for a party holding a swap position.
The idea
Credit risk in a swap arises only for the party to which the swap has positive value, because it is owed money. If the counterparty defaults, the loss is roughly the positive value at default less any recovery. A party with negative value has no credit exposure, though it still owes its liability. Exposure changes sign as rates and exchange rates move, so both parties can face exposure at different times. For the same counterparty, a netting agreement allows exposure to be computed on the sum of values. Exposure = max(sum of values − collateral, 0). Interest rate swaps carry a small exposure because only net payments are at risk. Currency swaps carry more because the principal is exchanged at maturity. Expected loss = probability of default × exposure × loss given default. The usual error is ignoring netting or collateral.
Formulas
Credit exposure to a counterparty with netting
exposure = max(sum of values − collateral, 0)
- sum of values
- the net value of all swaps with the counterparty under the netting agreement
- collateral
- collateral held against them
Only a positive net value is at risk. Multiply by loss given default, and by the default probability, for expected loss.
Expected loss on a swap exposure
expected loss = PD × exposure × LGD
- PD
- the probability of default
- exposure
- the positive value at risk after netting and collateral
- LGD
- loss given default, one minus the recovery rate
Ignoring netting or collateral overstates it.
A practice question
When does a party to a swap face credit risk from its counterparty?
- When the swap has a positive value to it, so that the counterparty owes it money. - correct
- Only when the swap's notional principal is exchanged at maturity.Why not: Interest rate swaps carry credit risk without any notional exchange; it is the positive value that matters.
- When the swap has a negative value to it, since it then owes the counterparty.Why not: A party that owes money has no credit exposure to the counterparty.
- Whenever the swap has been entered, regardless of its value.Why not: Credit exposure only exists when the swap has positive value to the party.
Credit exposure on a swap is max(value, 0): only a positive value represents a claim. Because value changes sign with market moves, exposure can move from one party to the other.
A harder one
Which statement about expected exposure over the life of a 5-year swap is correct?
- For a currency swap it is constant, because principal amounts are fixed.Why not: Exchange rate uncertainty and principal exchange mean the exposure keeps growing.
- For an interest rate swap it rises then falls, whereas for a currency swap it tends to keep rising toward maturity. - correct
- For both swaps it is highest at inception and falls steadily to maturity.Why not: The swap starts with zero value, so exposure is not highest at inception.
- For an interest rate swap it rises toward maturity as the final notional exchange nears.Why not: There is no notional exchange in an interest rate swap; its exposure falls as payments are made.
Interest rate swap exposure rises as uncertainty grows then falls as fewer payments remain. A currency swap's exposure keeps growing because the final principal exchange is exposed to exchange rate moves.
The hardest tier
A bank has three swaps with a counterparty under a netting agreement, with values of +USD 6.0 million, +USD 2.5 million and minus USD 4.0 million. It holds USD 1.5 million of collateral. If the counterparty defaults, the loss given default on the uncovered exposure is 60%. What is the bank's loss, in USD million?
- 2.70Why not: Ignores the collateral held against the net exposure.
- 3.00Why not: Ignores the loss given default and treats the whole uncovered exposure as lost.
- 1.80 - correct
- 4.20Why not: Does not net the negative swap against the positive ones.
Net exposure = 6.0 + 2.5 - 4.0 = 4.5. After collateral: 4.5 - 1.5 = 3.0. Loss = 3.0 x 60% = 1.80.
In the app: 6 practice questions on this outcome, spaced review that brings it back before you forget it.
Start free →More in Swaps
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