The Handbook of Credit Risk Management, 2nd Edition

CHAPTER 5Dynamic Credit Exposure

Unlike most loan facilities and other traditional transactions, certain financial arrangements generate a credit exposure whose amount is not a fixed number known at inception but, rather, one that changes over time. Two typical examples are derivative transactions of all kinds and long‐term supply or purchase agreements of commodities. The credit exposure is not fixed because it will fluctuate with the value of an underlying product on which the financial arrangement is based. These exposures are known as dynamic credit exposures. A variety of transactions generate dynamic credit exposures and it is impossible to describe them all in detail. However, they typically share some key features:

• They involve transactions of financial instruments such as foreign exchange, interest rates, or equities or goods whose values fluctuate (e.g., commodities such as oil and sugar).
• They have a long tenor, typically several years.
• In some cases, there is no exchange of cash or goods up front.
• Both parties commit to make a payment or to sell/buy a product in the future, at terms determined in advance.

What creates the dynamic credit exposure is the difference between the predetermined conditions and the prevailing ones at the time of the expected payment or sale/purchase. The following two sections introduce the two most common families of transactions generating dynamic credit exposure: long‐term supply or purchase agreements of physical commodities and derivatives ...