Say what a derivative is and show how trading derivatives exposes a party to counterparty credit risk.
The idea
A derivative is a contract whose value depends on an underlying asset, rate, index or event. Swaps, forwards, futures, options and credit default swaps are the main forms. Trading one creates counterparty credit risk, because the other side may default before the contract ends. Let V be the mark-to-market value of the contract to you. The exposure at any date is the greater of V and zero, so Exposure = max(V, 0). You lose only if the contract is worth something to you, and what you lose is the replacement cost, not the notional. Unlike a loan, this exposure is uncertain because V moves with markets. It can change sign, so the risk may run both ways, and it is a small fraction of notional. Settlement risk, where a full payment is made before the counterparty pays, is a separate and larger exposure. Exam point: expected loss is built on positive exposure, never on notional.
Formulas
Credit exposure on a derivative
exposure = max(V, 0)
- V
- the current mark-to-market value of the contract to you
You lose only when the contract is an asset to you; a liability is still owed to the defaulter's estate.
Expected credit loss on a derivative position
EL = EPE × PD × LGD
- EPE
- the expected positive exposure
- PD
- the counterparty's probability of default
- LGD
- loss given default
Assumes exposure and default are independent. Using the expected mark-to-market, which nets away negative outcomes, understates the loss.
A practice question
Which description best fits a derivative?
- A contract whose value derives from an underlying asset, rate, index or event - correct
- A claim on the residual earnings of a firm that ranks behind all of its creditorsWhy not: Describes an equity share, whose value comes from the firm's own cash flows rather than from a separate underlying.
- A pool of loans transferred to investors who receive the cash flows the loans generateWhy not: Describes a securitisation, a funded claim on assets, not a contract whose value is derived from an underlying.
- A secured cash loan made for a fixed term against collateral of equal valueWhy not: Describes a collateralised loan or repo, which is a funding transaction rather than a derivative.
A derivative is defined by the dependence of its value on an underlying variable such as a price, rate, index or credit event. Shares, securitised pools and secured loans are cash instruments.
A harder one
A swap dealer's position with a counterparty has a mark-to-market of negative USD 2 million to the dealer, and there is no collateral. The counterparty defaults with a recovery rate of 30 percent. The credit loss to the dealer on this position is:
- USD 1.4 million, found by applying the 70 percent loss rate to the USD 2 millionWhy not: Applies loss given default to a liability; the loss rate only applies to amounts the defaulter owes the dealer.
- USD 2.0 million, because a defaulted counterparty means the full value is lostWhy not: Treats a negative mark-to-market as a loss; it is an amount the dealer owes, not an asset.
- A gain of USD 1.4 million, because the dealer may settle at the 30 percent recovery rateWhy not: Assumes the dealer's own payable is reduced by recovery; the liquidator still collects the full amount due.
- None, because the dealer still owes the USD 2 million and has no claim to lose on - correct
Credit exposure is max(V, 0), here zero. The dealer must still pay the USD 2 million to the estate, so there is no credit loss and no windfall.
The hardest tier
A bank pays the EUR leg of a EUR 50 million FX transaction in the morning, expecting to receive USD later the same day. The counterparty fails before paying. Which statement is correct?
- Settlement risk: the loss can be the full principal of the paid leg, not just replacement cost - correct
- This is pre-settlement risk, so the loss is limited to the positive mark-to-market of the forwardWhy not: Mislabels the event; pre-settlement risk is replacement cost before any payment, whereas here principal has already left.
- This is market risk only, because the bank still holds the contract and may re-hedge it at current pricesWhy not: Overlooks that the counterparty has not paid and the paid principal is a credit exposure to a defaulted party.
- Close-out netting removes the loss, since the two payment legs offset each other in a single netted amountWhy not: Close-out netting applies after termination of open trades; it does not recover a payment already made and unmatched.
When one leg is delivered and the other is not, the full amount paid is at risk (settlement or Herstatt risk). Pre-settlement exposure, by contrast, is just the replacement cost of the open contract.
In the app: 6 practice questions on this outcome, spaced review that brings it back before you forget it.
Start free →More in Derivatives
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