Counterparty Credit Risk in Derivatives

Assessing the credit risk for a derivatives transaction is much more complicated than assessing the credit risk for a loan because the future exposure (i.e., the amount that could be lost in the event of a default) is not known. If a bank makes a $10 million five-year loan to a client with repayment of principal at the end, the bank knows that its exposure is approximately $10 million at all times during the five-year period. If the bank instead enters into a five-year interest rate swap with the client, the future exposure is much less certain. This is because the future value of the swap depends on movements in interest rates. If the value of the interest rate swap to the bank becomes positive, the exposure is equal to the value of the swap (because this is what the bank could lose in the event of a counterparty default). If the value becomes negative, the exposure is zero (because in that case the bank would not lose anything in the case of a counterparty default).

Derivatives that trade on exchanges entail very little credit risk. This is because, as explained in Chapter 7, the exchange stands between the two parties and has strict rules on the margin to be posted by each side. As mentioned in Chapter 13, legislators throughout the world now require most standardized over-the-counter derivatives transactions to be cleared through central clearing parties (CCPs). Like exchanges, CCPs stand between the two parties in derivatives ...

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