Credit Risk Explained and Tools
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Risk is an inherent part of the financial world. Some types of risk are more important than others though. In this article we are looking at credit risk involved in derivatives. Also some of the tools that can be used to mitigate credit risk. Credit risk is at the top of the different types of risk involved in derivatives.
Credit Risk The risk that a counterparty will fail to honour its obligations. In assessing credit, we need to determine the cost of replacing the transaction. In derivative terms we have: Current Exposure and Potential Exposure. Current exposure concerns the current replacement cost of the transaction. Potential exposure relates to the future replacement cost of the transaction. Managing credit risk can be achieved by credit limits or credit lines for counterparties. This can be based on credit profiles or previous behaviour. Credit risk profiles also differ according to the type of transaction undertaken. Credit risks for exchange traded derivatives are different from traded OTC. Tools and software available to deal with credit risk include:
Quantifi Risk from Quantifi Solutions Exchange Traded Instruments Due to the use of a clearing house, matched trades are cleared. Credit risk is therefore reduced to a minimum for these transactions. The clearing house's high credit rating and daily margining which settles any change on a daily basis. Credit risk between exchange members is eliminated. However a residual risk remains between the exchange member and a client. OTC Traded Instruments Credit risk in the context of OTC markets depends on the type of derivative. If the counterparty pays the premium in full at the start of the contract, then credit risk is eliminated for the selling bank. A "european" style option, generates credit risk if the option is exercised in-the-money (ITM) at expiry and the counterparty can not pay. Calculation of the credit risk in this scenario is a theoretical one. Replacement, in the absence of margining is based on gross replacement cost plus an estimate for any future changes in the contract value.
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