Credit Risk

Contracts such as swaps that are private arrangements between two companies entail credit risks. Consider a financial institution that has entered into offsetting contracts with two companies, A and B. (See Figure 5.3 or Figure 5.6.) If neither party defaults, the financial institution remains fully hedged. A decline in the value of one contract will always be offset by an increase in the value of the other contract. However, there is a chance that one party will get into financial difficulties and default. The financial institution would then still have to honor the contract it has with the other party.

Suppose that some time after the initiation of the contracts in Figure 5.3, the contract with company B has a positive value to the financial institution while the contract with company A has a negative value. If company B defaults, the financial institution would lose the positive value it has in this contract. To maintain a hedged position, it would have to find a third party willing to take company B's position. To induce the third party to take the position, it would have to pay the third party an amount roughly equal to the value of the financial institution's contract with B prior to the default.

A financial institution only has credit risk exposure from a swap when the value of the swap to the financial institution is positive. What happens when this value is negative and the counterparty gets into financial difficulties? In theory, the financial institution could realize a windfall gain since a default would lead to it getting rid of a liability. In practice, it is likely that the counterparty would choose to sell the contract to a third party or rearrange its affairs in some way so that its positive value in the contract is not lost. The most realistic assumption for the financial institution is therefore as follows. If the counterparty goes bankrupt, there will be a loss if the value of the swap to the financial institution is positive and there will be no effect on the financial institution's position if the value of the swap to the financial institution is negative. This situation is summarized in Figure 5.9.

Sometimes a financial institution can predict in advance which of two offsetting contracts is likely to have a positive value. Consider the currency swap in Figure 5.6. Sterling interest rates are higher than U.S. interest rates. As mentioned earlier, this means that as time passes the financial institution is likely to find that its swap with A has a negative value while its swap with B has a positive value. The creditworthiness of B is therefore far more important than the creditworthiness of A. In general, the expected loss from a default on a currency swap is greater than the expected loss from a default on an interest rate swap. This is because, in the case of a currency swap, principal amounts in different currencies are exchanged. In the case of both types of swaps, the expected loss from a default is much less



Figure 5.9 The Credit Exposure in a Swap than the expected loss from a default on a regular loan with approximately the same principal as the swap.

It is important to distinguish between the credit risk and market risk to a financial institution in any contract. As discussed earlier, the credit risk arises from the possibility of a default by the counterparty when the value of the contract to the financial institution is positive. The market risk arises from the possibility that market variables such as interest rates and exchange rates will move in such a way that the value of a contract to the financial institution becomes negative. Market risks can be hedged by entering into offsetting contracts; credit risks cannot be hedged. Credit risk issues will be discussed further in Chapter 18.

Avoiding Credit Card Disaster

Avoiding Credit Card Disaster

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