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Explain the conventional mechanisms by which a company can limit its exposure to credit risk.

FRM® Part I · Foundations of Risk Management · Credit Risk Transfer Mechanisms · FRM1.FR.4.b

The idea

Conventional ways to limit credit exposure start with diversification and limits by borrower, industry and country, so that no single default is large. Collateral and margin reduce the amount lost if a counterparty fails. Some exposure remains through thresholds, minimum transfer amounts and the delay before collateral is collected. Close-out netting combines positive and negative values under one enforceable master agreement into a single net claim. Exposure is then the larger of the net value and zero, not the sum of the positive trades. Other tools are guarantees, letters of credit, credit insurance, shorter maturities, and covenants or rating triggers that force repayment or extra collateral. Triggers can backfire because they demand cash exactly when a firm is weakest. Netting only works if it is legally enforceable, so exam answers should always check that condition.

Formulas

Counterparty exposure under close-out netting

exposure = max(V1 + V2 + … + Vn, 0)

V1, V2, Vn
the current values to the bank of the trades under one netting agreement

Only when netting is legally enforceable. Without it, exposure is the sum of the positive values alone.

A practice question

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

What does close-out netting accomplish when a counterparty defaults?

  1. It combines the positive and negative values of all trades into one net amount. - correct
  2. It cancels all of the defaulted counterparty's debts to its other creditors.Why not: Confuses bilateral netting with a bankruptcy discharge; other creditors' claims are unaffected.
  3. It lets the surviving party keep only the profitable trades and drop the losing ones.Why not: Describes cherry picking, which netting is designed to prevent.
  4. It requires the defaulter to post collateral equal to the gross sum of positive trades.Why not: Confuses netting with collateral; netting reduces exposure by offsetting, it does not call for margin.

Close-out netting replaces many gross claims with a single net claim, so the exposure is the larger of the net value and zero. It prevents cherry picking and depends on legal enforceability.

A harder one

A bank has four derivatives with one counterparty, all covered by a single enforceable netting agreement. The current values to the bank (USD million) are +12, -5, +7 and -9. Compared with the gross positive exposure of 19, the exposure to the counterparty after netting is closest to:

  1. USD 14 millionWhy not: Nets only the -5 trade against the positives (19 - 5) and ignores the -9 trade.
  2. USD 19 millionWhy not: Ignores netting and adds up only the positive values.
  3. USD 33 millionWhy not: Adds the absolute values of all four trades (12 + 5 + 7 + 9), which is not an exposure measure.
  4. USD 5 million - correct

Net value = 12 - 5 + 7 - 9 = +5. Exposure is max(net value, 0) = USD 5 million, compared with 12 + 7 = 19 without netting.

The hardest tier

A counterparty defaults while owing the bank on two trades: one worth +USD 20 million to the bank and one worth -USD 8 million to the bank. The recovery rate on unsecured claims is 40%. Without an enforceable netting agreement, the liquidator can demand the full USD 8 million while the bank is an unsecured creditor for the USD 20 million. How much smaller is the bank's loss with enforceable netting than without it?

  1. USD 4.8 million - correct
  2. USD 8.0 millionWhy not: Counts the full negative trade as the benefit and forgets that the gross claim would have recovered 40%.
  3. USD 7.2 millionWhy not: Reports the bank's loss with netting (12 x 0.6) rather than the difference between the two losses.
  4. USD 12.0 millionWhy not: Reports the bank's loss without netting (20 x 0.6) rather than the improvement from netting.

With netting the claim is 20 - 8 = 12, so the loss is 12 x 0.6 = 7.2. Without netting the bank pays 8 in full and recovers 40% of 20 = 8, so it loses 20 x 0.6 = 12. Netting saves 12 - 7.2 = USD 4.8 million, which equals 8 x 0.6.

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