Credit Exposure by Edu Pristine

Author of lecture Credit Exposure

Edu Pristine

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Excerpts from the accompanying material

... Learning Objectives, Define Presettlement Risk, Define Settlement Risk, Demonstrate Exposure Profiles of ...

... lending or issuance of bonds. Commitments: Zero exposure, but have potential ...

... EL, UL, Credit VaR and economic capital is a linear function of EAD. Exposure is the amount that we lose if the counterparty defaults. EAD tries to capture the likely ...

... Fails to perform on this deal or a related contract. Faces a rating downgrade. Goes bankrupt – in case of pre-settlement, the party with positive replacement cost receives a payment equal to replacement cost of the contract i.e. cost of entering similar contract ...

... transaction (say, delivery of security) while the other party defaults prior to settlement of its leg (payment). Example: Bank Herstatt, Germany – Herstatt’s banking license was withdrawn on 26th June 1974 and it was ordered into liquidation. Prior to cancellation of banking license, few overseas banks had irrevocably paid sizeable Deutschemarks to Herstatt during the day, in the good faith that they will receive USD during the same day as per ...

... payment date consists of both principal and interest component. Since principal is being repaid during the maturity, exposure keeps reducing with time.

... is uncertain since it depends on movement of the underlying (interest rates) which is stochastic (random). Usually, future exposure is maximum in the latter part of IRS maturity (say, in seventh year of a 10-year swap). FX Swap: Since there are no interim cash flows and no amortization risk when compared against a interest rate swap, potential of favorable ...

... A master agreement is a contract between two counterparties that specify rules that apply across several transactions between the two parties. ISDA (International Swaps and Derivatives Association) provides standard master agreements that may be used by banks for their OTC transactions. ISDA advocates closure of all transactions covered under the netting agreement at their replacement value (called ‘bilateral close-out netting’). ...

... it would had to go to bankruptcy court. Now it can simply settle the net amount of 65-15 = 50. Collateral: Capital is required on (Exposure – Collateral value). In traditional banking, a bank might issue a Bank guarantee (or open a letter of credit) on behalf of a customer against (say) 20% cash margin. Capital is therefore required on 80% of the exposure. For capital calculation, collateral value is reduced by ...

... external rating of the counterparty. Third party guarantees: Risk is substituted from the counterparty to the guarantor. Just like collateral, there is a probability that the guarantor might also default. Credit derivatives: like CDS etc. may be used to buy protection for defaults by the counterparty. ...