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Spot the risks attached to OTC markets and set out ways to mitigate them.

FRM® Part I · Financial Markets and Products · Exchanges and OTC Markets · FRM1.FM.5.g

The idea

OTC markets carry several linked risks. Counterparty credit risk is the main one. A bilateral contract with positive value to you is a claim on a counterparty who may default. The expected loss is roughly: Expected loss = exposure × probability of default × loss given default. Wrong-way risk arises when exposure rises as the counterparty's credit worsens. Settlement risk appears when one leg is paid before the other is received, as in foreign exchange. Liquidity risk comes from tailored contracts that are hard to unwind. Operational and legal risk comes from documentation and the enforceability of netting. Opacity can hide concentrations and spread contagion. Mitigants include close-out netting, collateral under a credit support annex, central clearing for standard products, credit limits, rating triggers, payment-versus-payment settlement, diversification, and credit valuation adjustment priced into the trade. Match each mitigant to the risk it addresses.

Formulas

Expected credit loss on an OTC exposure

expected credit loss = exposure × PD × (1 − recovery rate)

exposure
the amount at risk, net of any enforceable netting
PD
the probability of default
recovery rate
the share of the claim recovered after default

An approximation that treats exposure, default and recovery as independent. It understates the loss under wrong-way risk, when exposure rises as the counterparty weakens.

A practice question

From the question bank, with the reason each wrong option is wrong.

What is the main risk of a bilateral OTC derivative that has positive value to one party?

  1. Margin risk, because daily variation margin cannot be avoidedWhy not: Bilateral trades may have no margin at all; this describes futures.
  2. Position-limit risk, because exchanges cap holdingsWhy not: Position limits are an exchange mechanism, not a bilateral OTC risk.
  3. Counterparty credit risk, since the other party may default - correct
  4. Standardisation risk, because contracts are all identicalWhy not: OTC contracts are customised; identical terms are an exchange trait.

In a bilateral OTC trade the party with positive value is exposed to the other's default. That exposure is the main reason for netting, collateral and clearing.

A harder one

A bank buys credit default protection on a sovereign's bonds from a large bank headquartered in the same sovereign. What risk is most prominent?

  1. Wrong-way risk: protection gains value as the seller weakens. - correct
  2. Right-way risk: the protection gains value when the seller is healthiest.Why not: Reverses the relationship; the seller is weakest exactly when the sovereign is in distress.
  3. Basis risk between the CDS spread and the bond yieldWhy not: Basis risk concerns pricing mismatches, not correlation between exposure and the seller's credit.
  4. Settlement risk from simultaneous exchange of cash flowsWhy not: The protection leg and the premium leg settle over time without the paying-before-receiving problem.

Wrong-way risk occurs when exposure and counterparty default probability rise together. A domestic bank selling sovereign protection is likely to weaken as the sovereign weakens.

The hardest tier

A dealer's credit support annex says that if its rating falls below a stated level it must post additional collateral. Which statement is correct?

  1. It removes counterparty risk for the dealer, which is the party posting collateral.Why not: The trigger gives the counterparties credit protection; it does not protect the poster.
  2. It increases the dealer's credit exposure because the counterparty holds its collateral.Why not: Collateral held by the counterparty reduces that counterparty's exposure to the dealer.
  3. It protects counterparties but drains the dealer's liquidity when weakest. - correct
  4. It has no effect on the dealer until it actually defaults.Why not: Contingent calls bite on a downgrade, well before any default.

A rating trigger shifts risk from the counterparties to the dealer's liquidity. A downgrade forces collateral calls at the worst moment, which is a procyclical feature of triggers.

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