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Outline how funding exposure differs from credit exposure.

FRM® Part II · Credit Risk Measurement and Management · Future Value and Exposure · FRM2.CR.19.g

The idea

Credit exposure and funding exposure look at opposite sides of a derivative. Credit exposure is the loss if the counterparty defaults when the contract has positive value to the firm, so it relies on the positive mark-to-market, net of collateral held. Funding exposure is the cash or securities the firm must find, and pay for, when it has to post collateral or pay out. That is typically when its own mark-to-market is negative. Even a perfectly hedged book can have a funding need. Suppose a client trade is uncollateralised and its hedge is under a margin agreement. The firm then posts margin on the hedge whenever the client trade gains, and receives none from the client. The expected funding need mirrors the positive exposure of the client trade. Funding is a liquidity and cost issue, not a default loss.

Formulas

Cost of funding posted margin

Funding cost = Margin × (Funding rate − Collateral rate)

Margin
the collateral posted
Funding rate
the rate the firm pays to raise it
Collateral rate
the rate it earns on the posted collateral

A yearly cost of liquidity, not a default loss. Charging the full funding rate ignores the interest received on the collateral.

A practice question

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

Which statement best distinguishes funding exposure from credit exposure on a derivative?

  1. Credit exposure is measured on the negative mark-to-market values and funding exposure on the positive mark-to-market valuesWhy not: Reversed: credit exposure arises from positive value, and funding needs mainly from negative value.
  2. Funding exposure is the replacement cost on a counterparty default, while credit exposure is the cost of raising cash and collateralWhy not: Swaps the two definitions.
  3. Credit exposure is the default loss when the counterparty owes the firm; funding exposure is the cash or collateral the firm must provide and finance - correct
  4. They are the same quantity measured at different confidence levelsWhy not: They concern different sides of the mark-to-market and different risks: default loss versus the cost of liquidity.

Credit exposure is about the counterparty's default when the firm is owed money. Funding exposure is about the firm's own need to finance margin or payments, which is greatest when the mark-to-market is against it.

A harder one

A dealer faces a corporate client on an uncollateralised swap and hedges it with an offsetting swap with an interbank dealer under daily zero-threshold margining. Rates move so the client swap gains and the hedge loses. What is the dealer's issue?

  1. It has no exposure of any kind, since the two swaps offset exactly in mark-to-market termsWhy not: The mark-to-market offsets but collateral flows do not: margin is posted on one swap only.
  2. It receives collateral on the hedge and so has a funding surplusWhy not: The hedge has lost value, so the dealer posts margin rather than receiving it.
  3. It has credit exposure to the interbank dealer equal to the margin posted, and no funding implicationsWhy not: Posting margin has to be financed, which is a funding cost.
  4. It posts margin on the hedge but receives none from the client, creating a funding need as well as credit exposure - correct

The hedge is a liability, so variation margin goes out, while the client's gain is unsecured and brings no collateral in. The dealer must fund the difference and also bears credit exposure to the client.

The hardest tier

A dealer's uncollateralised client swap is hedged by an exactly offsetting swap under daily zero-threshold variation margin. The expected amount of margin the dealer must post on the hedge over time is best linked to which quantity on the client trade?

  1. The client trade's expected positive exposure, since the hedge needs margin when the client trade is an asset - correct
  2. The client trade's expected negative exposure, since the margin is posted whenever the client trade is a liabilityWhy not: Reversed: margin is posted on the hedge when the client trade gains, and the hedge, not the client trade, has the liability.
  3. The client trade's expected mark-to-market, since gains and losses on the two swaps offset each other in the margin flowsWhy not: Margin is posted only on the hedge's losses; gains on the client side bring no collateral, so there is no netting.
  4. The client trade's 99% PFE, since margin must cover the worst caseWhy not: Variation margin follows realised mark-to-market, not the percentile.

Posted margin = max(-V_hedge, 0) = max(V_client, 0), so the expected margin posted equals the client trade's EE. Funding exposure mirrors the credit exposure of the client trade.

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