Business, Legal & Accounting Glossary
Credit risk used to be primarily a concern of banks, fixed income investors, and businesses that extended credit as part of their business. The growth of derivatives markets during the 1990s introduced new forms of credit risk, not only for the derivatives dealers who made markets in them, but also for the corporations who used them.
Not all derivatives entail credit risk. For example, futures are traded on exchanges that employ a system of margining that virtually eliminates credit risk. However, most OTC derivatives entail credit risk for one or both parties to the transaction. If a dealer sells a corporation a call option, the corporation pays the dealer a premium and faces the risk that the dealer may fail to perform on the option in the event the corporation exercises it in-the-money. If, on the other hand, the dealer enters into an interest rate swap with the corporation, no premium is paid, and the swap starts off with no market value (except, perhaps, that due to a bid-ask spread charged by the dealer). Depending upon fluctuations in interest rates, the swap could take on a positive market value for either the dealer or the corporation. Accordingly, both face credit risk due to the possibility that the swap might come to represent a net obligation of the other party.
OTC derivatives actually entail two forms of credit risk:
Settlement risk entails a number of unique issues. In this article, we focus on pre-settlement risk.
Many OTC derivatives are structured with termination features. These provide for the immediate termination of the contract should a specified trigger event occur. Trigger events might include:
When a trigger event occurs, the contract is terminated (either automatically or at the option of the other counterparty) and there is an immediate cash settlement between the counterparties for any market value of the contract.
Accordingly, a pre-settlement default might entail the following elements:
Unlike settlement risk, which entails exposure equal to a counterparty’s gross obligation, pre-settlement risk entails exposure equal to a counterparty’s net obligation on that contract. Suppose an institution enters into a forward contract to exchange 1MM GBP for 1.5MM USD in three months. Settlement risk exposes the institution to a possible loss of $1.5MM. Pre-settlement risk exposes the institution to just the difference in market value between the USD and GBP payments. If the pound were trading at 1.45 USD/GBP at the time of a default, this would translate into a loss of just USD 50,000.
Replacement cost is a basic metric of credit exposure due to pre-settlement risk. It is the cost that an institution would incur if a counterparty completely defaulted on its obligations. Effectively, it is the cost to the institution of having to completely replace all contracts with that counterparty.
Current replacement cost (called mark-to-market exposure) is the replacement cost of a portfolio of contracts with a counterparty based upon those contracts’ current market values. Replacement cost is distinct from market value for two reasons:
Replacement cost can never be negative. This reflects the fact that an institution will never benefit from a counterparty default. Even if a counterparty fails, obligations owed to the counterparty must be paid. Accordingly, if a contract has a negative market value, it has a zero replacement cost.
Unless an enforceable netting agreement applies, offsetting obligations will not net in a default situation. Specifically, an institution will have to meet its obligations to a counterparty despite that counterparty failing to perform on offsetting obligations.
For example, suppose that an institution has two contracts with a counterparty which have the following market values:
If there is not an enforceable netting agreement between the two parties, the replacement cost of the portfolio is $3MM. This is because, if the counterparty were to default, the institution would still have to perform on its $5MM obligation. The only contract that would be affected by the default would be the $3MM contract. Accordingly, the institution has $3MM at risk.
If, on the other hand, there is an enforceable netting agreement, the replacement cost is $0. In the event of a default, the two obligations would be netted, and the institution would be obligated to the counterparty for $2MM—the same net obligation it has without a default.
Accordingly, depending upon whether there is a netting agreement, the replacement cost is either $3MM or $0. Each result is different from the portfolio’s market value of –$2MM.
Replacement cost can also be measured prospectively. Future replacement cost is the discounted value of the replacement cost of a portfolio of contracts with a counterparty, based upon what those contracts’ market values would be under a specified market scenario. Obviously, the result depends upon the assumed scenario. Statistical risk measures such as expected credit exposure summarize what future replacement cost may be based upon the entire probability distribution of possible market scenarios.
Suppose an institution is about to enter into a foreign exchange forward contract with a counterparty. With such a contract, the initial market value is zero—except, perhaps for a bid-ask spread. Accordingly, its current replacement cost (or mark-to-market credit exposure) is zero. This, however, gives no indication of the potential credit exposure from the contract. As the underlying exchange rate fluctuates, the contract could take on a positive replacement cost. Indeed, if the exchange rate moves significantly in the institution’s favor, the replacement cost could become quite large.
When that happens, it will be too late for the institution to start managing its credit exposure to the counterparty. The time to do so is now—while the institution is still negotiating the contract. Only now can the institution decide whether or not to enter into the contract. Only now, can it incorporate credit enhancements into the deal. The institution cannot base its actions on the mark-to-market credit exposure of the contract, which is zero. Somehow, it must analyze the potential credit exposure.
There are two statistical measures of potential credit exposure that are commonly used. They are closely related:
The term potential exposure is used to refer to expected exposure, maximum likely exposure or any similar metric of possible future exposure.
In complex portfolios, with multiple contracts maturing or paying cash flows on various dates, potential credit exposure can vary significantly from one horizon to the next.
Specifically, this means that expected exposure and maximum likely exposure are horizon-specific notions. A portfolio does not have a single expected exposure or maximum likely exposure. Instead, those measures of exposure will vary for a portfolio depending upon which horizon they are calculated over. Accordingly, exposure is typically calculated for multiple horizons.
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Definitions for Pre-Settlement Risk are sourced/syndicated and enhanced from:
This glossary post was last updated: 17th April, 2020 | 0 Views.