VOLUME 1, NUMBER 25/August 28, 1995
***************************************************************** DERIVATIVES 'R US is a weekly non-profit publication on the Internet user group misc.invest.futures that provides a simple non-technical treatment of various topics in derivatives. DRU is written by Don M. Chance, Professor of Finance at the Center for the Study of Futures and Options Markets at Virginia Tech. He can be contacted at dmc @ vt.edu or by phone at 540-231-5061 or fax at 540-231-4487. DRU is for educational purposes only and does not provide trading advice. Back issues of DRU available by anonymous ftp from fbox.vt.edu/filebox/business/finance/dmc/DRU or can be accessed using a Web browser at http://fbox.vt.edu:10021/business/finance/dmc/DRU. The file contents.txt can be viewed to see a list of old filenames and topics available for reading or downloading. *****************************************************************
CREDIT RISK IN DERIVATIVES
For many years derivatives users have proceeded with little attention to the possibility that the counterparty would default. The exchange clearinghouses provided an assurance that they would step in when one side defaulted. That has indeed been the case in several episodes. Even the interbank currency market, an over-the-counter market for forward contracts on currency, has had a remarkable record for credit performance. With the explosion of more and more over-the-counter derivatives, however, concerns have increased that more defaults will occur. These concerns are certainly justified. The growing use and increasing complexity of derivatives combined with the lack of knowledge of both the instruments and the appropriate way to measure and manage credit risk give everyone reason to need a better understanding of the credit risk problem.
The credit risk of an OTC derivative is a function of several factors. The most basic factor is the nature of the instrument. Credit is a considerably different concern in options than in forwards or swaps. Another important factor is the value of the derivative. Another is the credit quality of the counter parties. Finally, market conditions are important to consider. (Have I left out any? Please reply).
Consider an option. The buyer doesn't have to do anything so he is not a risk to the writer. The buyer assumes the risk that the writer will default. Prior to expiration an option nearly always has value, so the buyer is virtually never without some default risk. A forward contract, however, can have positive value to one but not both parties. At the time a forward contract is created, it has zero value. As the price of the underlying changes, one party gains and the other loses. The party to which the contract has positive value is, thus, holding an asset and is subject to the risk that the other party will default. Of course, it might not take much of a change in the value of the underlying for this counterparty to find himself holding a liability. In that case, the other party would assume the risk of default.
Because a forward contract is similar to a swap, the general considerations in analyzing credit risk are similar. However, a swap is a series of future payments whereas a forward contract is but one future payment.
For a swap, the risk of default can take on two forms. One is the current risk, which is the risk that any payments due immediately cannot be made. The other is the potential risk, which is the risk that future payments cannot be made. Potential risk is much harder to gauge and is typically done by simulating future market conditions combined with best estimates of the counterparty's ability to pay under those conditions.
However, keep in mind that a swap involves a series of payments from each side to the other. Because each party bears risk from the other party, the risks serve to partially offset. Thus, a floating for fixed swap between two parties of high credit quality would entail extremely low credit risk. Only the net amount owed would be at risk and each party would accept the other's credit risk in return for a bilateral acceptance of his own credit risk. Moreover, since such a swap does not involve payment of the notional principal, the amount at risk is quite small.
For that reason, the credit risk of swaps is remarkably small relative to the credit risk assumed in a bond, note, or commercial loan. In a typical such arrangement, the lender remits say $10 million, perhaps unsecured to a corporation, and expects to receive a stream of interest payments of say 8 % a year for three years after which it expects to get back the $10 million. This kind of transaction happens every day. In a swap, the principal is not at risk and only the net interest payment is made. On some payment dates, one party makes the payment; on others, the other party makes the payment. So the stream of interest payments at risk has a very good chance of being only about one-half of what they would be under a loan. The actual risk is estimated to be only 1-2 percent of the notional principal.
Of course, none of this should be taken to mean that there is no credit risk. Indeed there are reasons to be concerned. An individual transaction may appear to have little credit risk but if the party is engaged in numerous transactions and does a poor job of managing the risk, the likelihood of a default is much higher.
There are several ways in which the parties can manage the credit risk. Probably the most common is based on the principle of diversification: you limit the amount of business you do with a given party. Another method used is collateral. A typical transaction might require no collateral up front but as underlying prices or rates move, collateral might be posted. Swap subsidiaries have been devised by many swap dealers to separate the swap business from the banking or investment business. This can permit the subsidiary to acquire a higher rating than its parent company. The number of these subsidiaries, called Special Purpose Derivatives Vehicles or Enhanced Derivatives Products Companies, has increased at a somewhat slow rate but they are likely to continue to appear.
Some swap contracts require marking to market, just as in the futures market. Though not done daily, the marking to market is done in much the same way. Any net gain or loss is distributed and the swap is rewritten at the current market rate for a swap with that remaining tenure.
If the two parties have many transactions, then netting can be arranged to reduce the risk. For example, suppose XYZ does numerous swaps (and even other derivatives) with a particular dealer. Some of those transactions have positive value to XYZ and some have negative value. Suppose XYZ defaults. Then without netting, XYZ might find that it could default on all contracts in which it owes the dealer more than the dealer owes it and demand payment on the contracts in which the dealer owes it more than it owes the dealer. This practice called cherry picking is considered unhealthy and exacerbates the credit risk. Nor should the non-defaulting party be able to walk away from amounts that it owes to the defaulting counterparty. A netting arrangement can provide that only the net amount of all of the transactions between the two parties is owed.
The credit risk issue is a complex one but it may well be much ado about nothing. The markets have done a remarkable job of managing this risk. Actual credit losses have been quite large. Interestingly, one of the largest defaults was induced by the U.K. government. The London borough of Hammersmith and Fulham had entered into a number of swaps that had negative market value. A U.K. court invoked the doctrine of ultra vires, declaring that the municipality had no authority to enter into the swaps in the first place. This ruling was upheld by the House of Lords in 1991. The resulting defaults accounted for about one-half of all swap defaults recorded up to that time.
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DERIVATIVES QUOTE FOR THE WEEK
"The market can deal with almost anything as long as people think they'll get paid."
Gerald Corrigan, Goldman Sachs and former President of the Federal Reserve Bank of New York Quoted in Business Week, October 31, 1994, p. 104