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Outline which transactions bear counterparty risk and show how the risk emerges in each.

FRM® Part II · Credit Risk Measurement and Management · Counterparty Risk and Beyond · FRM2.CR.15.b

The idea

Counterparty risk arises wherever a transaction leaves one party owing the other something that depends on future events. In OTC derivatives it is the positive mark-to-market of the contract. For example, a fixed-rate payer holds a claim after rates rise. In repos, reverse repos and securities lending, the exposure is the gap between the collateral and what was lent. A cash lender loses if the bonds it holds fall below the cash. A securities lender loses if the securities rise above the collateral it holds. In settlement, the risk is paying away your leg before the other party delivers theirs, as in FX trades with no payment-versus-payment arrangement. Exchange-traded and cleared contracts shift exposure to a central counterparty. Exam point: always locate the party whose position is in the money, because only that party is exposed.

A practice question

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

In a securities lending transaction in which the lender holds cash collateral, counterparty risk emerges for the lender if:

  1. the borrower defaults when the market value of the securities lent has fallen below the collateral held.Why not: Reverses the direction: a fall in the securities' value leaves the lender over-collateralised.
  2. the borrower returns the securities on the agreed date and the lender returns the cash collateral.Why not: That is normal settlement; no default occurs, so no counterparty loss arises.
  3. the borrower defaults when the market value of the securities lent has risen above the collateral held. - correct
  4. the lender's own credit rating is downgraded while the loan is outstanding.Why not: The lender's rating is the borrower's exposure to the lender, not the lender's counterparty risk.

The lender gave up securities and holds cash. If the securities are worth more than the cash when the borrower defaults, the lender cannot buy them back with the collateral, so it takes a loss.

A harder one

A dealer enters a five-year swap in which it pays fixed and receives floating from a corporate. Interest rates then rise sharply. Which statement correctly locates the counterparty risk?

  1. The corporate is exposed to the dealer, because the corporate receives fixed payments that are now below the market rate.Why not: Reverses the sign: the fixed receiver lost value when rates rose, so the corporate is the one that owes.
  2. The dealer is now exposed to the corporate, because the pay-fixed swap has gained value to the dealer. - correct
  3. Both parties are equally exposed, because the swap has the same notional for both.Why not: Exposure depends on the sign of the mark-to-market, not on the notional, and only one party is in the money.
  4. Neither party is exposed, because a swap exchanges no principal at maturity.Why not: No principal exchange limits the size of the exposure but does not eliminate it; a positive mark-to-market is still at risk.

A fixed-rate payer gains when rates rise, since it pays a below-market rate. A gain is a claim on the counterparty, so the dealer carries the counterparty risk.

The hardest tier

Which statement about the typical expected exposure profile of a long-dated interest rate swap compared with a long-dated FX forward is correct?

  1. Both profiles are hump-shaped, because in each case the number of remaining cash flows declines steadily as maturity approaches, which pulls exposure back down.Why not: An FX forward has a single final exchange, so there is no amortisation to pull exposure down before maturity.
  2. The swap profile rises steadily to maturity, while the FX forward profile falls to zero as maturity approaches.Why not: Reverses the shapes: the swap's exposure shrinks as remaining payments fall, and the forward's grows with uncertainty.
  3. The swap profile is hump-shaped, rising and then falling to zero as payments are exchanged, while the FX forward profile tends to rise towards maturity. - correct
  4. Both profiles are flat, because exposure is set by the notional and does not change over time.Why not: Exposure is the mark-to-market, which changes as markets move; notional alone does not set it.

For a swap, uncertainty grows with time but the number of remaining payments falls, producing a hump. An FX forward has one cash flow, so uncertainty keeps growing until maturity.

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