Understanding Credit Risk Profiles of Over-the-Counter Derivative Transactions
Posted: 1 November 2014
There are two types of financial derivative transactions, namely exchange-traded and over-the- counter (OTC) derivative transactions. Exchange-traded transactions are executed on exchanges where an exchange will be one of the counterparties for every transaction and guarantees the payment as per the contract. OTC transactions are executed by two parties outside exchange.
Exchange-traded transactions are standardized contracts, whereas the OTC transactions can be customized as per convenience of the counterparties involved. As one of the counterparties in the exchange-traded derivative transactions is the exchange itself, credit risk involved in the transaction is almost nil, because the probability of default for these exchanges will be close to zero. However, there is huge amount of credit risk in the OTC derivative transactions, as the counterparties may not be sufficiently liquid or strong enough to honor the payments as per agreement.
The credit risk for such transactions can be calculated by various measures, such as current exposure and potential future exposure (PFE). While current exposure (which is calculated by the net replacement cost method) is a static measure, PFE is forward looking and is used by most of the investment banks in the calculation of both credit valuation adjustment (CVA) and economic capital. It is also used in setting the trading limit for counterparties.
With the increase in the range of application of PFE, it has become important to understand the potential future exposure involved in different types of instruments, like forwards, interest rate swaps and cross currency swaps. This paper tries to explain the PFE profiles for various major instruments and the sensitivity of the PFE profiles to changes in the trade parameters, such as time to maturity and notional and payment frequencies.