Dynamic Credit Exposures

BAF 356 : Credits and

• Unlike most loan facilities and other traditional transactions, certain financial
Debt Management arrangements generate a credit exposure whose amount is not a fixed
number known at inception but, rather, one that changes over time.
Sixth Week
• Two typical examples are derivative transactions of all kinds and long-term
Dynamic Credit Exposures (Derivatives) 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.

Dynamic Credit Exposures Long-term supply agreements

A variety of transactions generate dynamic credit exposures and it is impossible to • Long-term supply agreements involve one party committing to sell a product
describe them all in detail. However, they typically share some key features:
like oil or sugar for a long period of time and another one committing to
• They involve transactions of financial instruments such as foreign exchange, interest accept deliveries and to make payments.
rates or equities, or goods whose values fluctuate (e.g., commodities such as oil and
sugar). • The price is set at the inception of the agreement and is valid until
• They have a long tenor, typically several years. termination.
• 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.
 Long-term supply agreements Long-term supply agreements
Prices of Brent Crude Oil, January 2010 to August 2012 • Let us illustrate long-term supply agreements with a concrete example. Utility companies,
say, for example, Utility Corp., generate electricity from power plants they own and sell it to
individual and industrial customers.
• They build power plants, which are expensive, and require long-term financing, typically no
less than 10 years. The financing faces the major challenge of forecasting expenses and
revenues over a long period of time.
• Lenders need to be comfortable with the stability of the expenses, primarily the costs of
operating the plant, and of the revenues generated by the sale of electricity to customers.
• A major portion of the operating expenses stems from the purchase of oil, a commodity

Long-term supply agreements Long-term supply agreements

• Prices of commodities fluctuate a lot, as shown in Figure because they are influenced by
rapid changes of macroeconomic conditions or by the occurrence of political events.
• To avoid being exposed to the volatility of prices, which would make financing nearly
impossible, utilities enter into long-term contracts with commodity producers and traders,
like Traders & Co. In exchange for the commitment to be delivered a given quantity of oil,
Utility Corp. agrees to buy a predetermined amount from Traders & Co. for a set price over
a long period of time.
• In doing so, they eliminate their exposure to the fluctuations of the market price and their
cash outflows are known in advance, which satisfies theirfinanciers. The contract between
Utility Corp. and Traders & Co. is known as a long-term supply agreement.
 Long-term supply agreements
• The supply contract, therefore, generated a credit risk for Utility Corp.
because, when Traders & Co. defaulted, Utility Corp. suffered a financial loss.
Three main parameters influenced the magnitude of the loss:
• 1. The agreed price ($3).
• 2. The remaining lifetime of the contract (four years).
• 3. The market price at the time of Traders & Co.'s default
Derivative Products
• Derivatives are financial instruments that companies use to hedge against risk
or to speculate on price movements.
• The most common derivatives involve interest rates, foreign exchange,
equities, and commodities (e.g., oil). They are technically very similar. In most
cases, there are no exchanges of cash at the inception (e.g., start date) of a
derivative contract.
• However, the simple fact of entering into a contract generates a credit risk
for the two parties involved.
Long-term supply agreements
• This creates a serious challenge for a credit risk manager who is asked to sign
off on the exposure to the counterparty. In addition to the long-term nature
of the contract, which generates a high degree of uncertainty around the
evolution of the credit quality, the risk manager does not know with certainty
the amount of credit risk his firm will be taking over the lifetime of the
contract.
Derivative Products
• Derivatives are financial instruments that companies use to hedge against risk
or to speculate on price movements.
• The most common derivatives involve interest rates, foreign exchange,
equities, and commodities (e.g., oil). They are technically very similar. In most
cases, there are no exchanges of cash at the inception (e.g., start date) of a
derivative contract.
• However, the simple fact of entering into a contract generates a credit risk
for the two parties involved.
 Derivative Products
• Most derivatives are traded over-the-counter (OTC).
• However, some of the contracts, including options and futures, are traded on
specialized exchanges.
• The biggest derivative exchanges include the CME Group (Chicago
Mercantile Exchange and Chicago Board of Trade), the Korea Exchange,
and Eurex
Types of Derivatives
1. Forwards and futures
• These are financial contracts that obligate the contracts’ buyers to purchase
an asset at a pre-agreed price on a specified future date. Both forwards and
futures are essentially the same in their nature.
• However, forwards are more flexible contracts because the parties can
customize the underlying commodity as well as the quantity of the
commodity and the date of the transaction. On the other hand, futures are
standardized contracts that are traded on the exchanges.
Derivative Products
• Derivatives are not new financial instruments.
• For example, the emergence of the first futures contracts can be traced back
to the second millennium BC in Mesopotamia.
• However, the financial instrument was not widely used until the 1970s.
• The introduction of new valuation techniques sparked the rapid
development of the derivatives market. Nowadays, we cannot imagine
modern finance without derivatives.
Types of Derivatives
2. Options
• Options provide the buyer of the contracts the right, but not the obligation,
to purchase or sell the underlying asset at a predetermined price.
• Based on the option type, the buyer can exercise the option on the maturity
date (European options) or on any date before the maturity (American
options).
 Types of Derivatives Types of Derivatives
3. Swaps 3. Swaps
• Swaps are derivative contracts that allow the exchange of cash flows between • Swaps are derivative contracts that allow the exchange of cash flows between
two parties. two parties.
• The swaps usually involve the exchange of a fixed cash flow for a floating • The swaps usually involve the exchange of a fixed cash flow for a floating
cash flow. cash flow.
• The most popular types of swaps are interest rate swaps, commodity swaps, • The most popular types of swaps are interest rate swaps, commodity swaps,
and currency swaps. and currency swaps.

Advantages of Derivatives Advantages of Derivatives

1. Hedging risk exposure 2. Underlying asset price determination
• Since the value of the derivatives is linked to the value of the underlying • Derivatives are frequently used to determine the price of the underlying
asset, the contracts are primarily used for hedging risks. asset.
• For example, an investor may purchase a derivative contract whose value • For example, the spot prices of the futures can serve as an approximation of
moves in the opposite direction to the value of an asset the investor owns. a commodity price.
• In this way, profits in the derivative contract may offset losses in the
underlying asset.
 Advantages of Derivatives
3. Market efficiency
• It is considered that derivatives increase the efficiency of financial markets.
• By using derivative contracts, one can replicate the payoff of the assets.
• Therefore, the prices of the underlying asset and the associated derivative
tend to be in equilibrium to avoid arbitrage opportunities.
Advantages of Derivatives
4. Access to unavailable assets or markets
• Derivatives can help organizations get access to otherwise unavailable assets
or markets.
• By employing interest rate swaps, a company may obtain a more favorable
interest rate relative to interest rates available from direct borrowing.

Disadvantages of Derivatives Disadvantages of Derivatives

• Despite the benefits that derivatives bring to the financial markets, the 1. High risk
financial instruments come with some significant drawbacks. • The high volatility of derivatives exposes them to potentially huge losses.
• The drawbacks resulted in disastrous consequences during the Global The sophisticated design of the contracts makes the valuation extremely
Financial Crisis of 2007-2008. complicated or even impossible.
• The rapid devaluation of mortgage-backed securities and credit-default • Thus, they bear a high inherent risk.
swaps led to the collapse of financial institutions and securities around the
world.
 Disadvantages of Derivatives
2. Speculative features
• Derivatives are widely regarded as a tool of speculation.
• Due to the extremely risky nature of derivatives and their unpredictable
behavior, unreasonable speculation may lead to huge losses.
The Economic Value of A Contract
• The fundamental thing to remember is that, once a contract has been signed,
there is a possibility that one party loses money if the other party defaults,
even if there is no exchange of cash or products at inception.
• As a consequence, the simple fact of entering into a transaction generates
credit risk.
• The only case in which there would not be credit risk is if the market price
of the underlying product were somehow constant, which naturally does not
happen in real life.
Disadvantages of Derivatives
3. Counter-party risk
• Although derivatives traded on the exchanges generally go through a
thorough due diligence process, some of the contracts traded over-the-
counter do not include a benchmark for due diligence.
• Thus, there is a possibility of counter-party default.
Mark-to-market Valuation (MTM)
• For most credit risk managers, what is really important is to identify when
transactions generate a credit exposure and to have a general understanding
about its nature.
• The actual valuation of dynamic exposures is very complex. It is another
science that typically involves sophisticated quantitative models.
• Thankfully, there is really no need to be able to calculate an MTM exposure
to be a good credit risk manager. Naturally, the more one knows, the better,
though.
 Mark-to-market Valuation (MTM)
• There are three major parameters that influence the mark-to-market value of
a contract and thus the credit risk it generates:
1. The predetermined conditions of the contract (e.g., $3 per gallon).
2. The time left in the contract. All things being equal, the longer the time, the
larger the value.
3. The prevailing conditions at the time the computation is performed.
VALUE AT RISK (VaR)
• With MTM, we calculate the economic value of a contract based on the
prevailing price, and we arrive at a point estimate. The idea behind VaR is to
add a probability dimension to the MTM concept. What is the likelihood that
the price reaches a certain level and, if so, what is the corresponding MTM
value of the contract?
Mark-to-market Valuation (MTM)
• For credit risk managers, the list of MTM values provides an overview of the
exposures they have to manage. Those values have to be compared with the
approved limits to make sure that the risks taken are in line with the firm’s appetite.
• Furthermore, when a default occurs, many people inside a firm, such as senior
management and compliance officers, and outside the organization, such as
regulators, rating agencies, and equity analysts, want to know immediately what the
financial consequences are.
• In an era when everybody is accustomed to receiving information on a real-time
basis, risk managers need to have the MTM numbers handy all the time, for all
contracts and on all counterparties.
VALUE AT RISK (VaR)
Probability Distribution of MTM Values
 VALUE AT RISK (VaR)
• The area below the curve represents the probability associated with all
possible outcomes scenarios, which is 100 percent by construction.
• At a given MTM value, the area below the curve, up to that point, represents
the probability of the product's MTM value being at or below that amount.
• For example, point A represents a 50 percent probability that the product's
MTM will be at or below $65, and point B represents a 75 percent
probability that the product's MTM will be at or below $90.
HOMEWORK
• Please summarize essential terms
VALUE AT RISK (VaR)
• The area below the curve represents the probability associated with all
possible outcomes scenarios, which is 100 percent by construction.
• At a given MTM value, the area below the curve, up to that point, represents
the probability of the product's MTM value being at or below that amount.
• For example, point A represents a 50 percent probability that the product's
MTM will be at or below $65, and point B represents a 75 percent
probability that the product's MTM will be at or below $90.
Link
• To learn more about the purpose and components of each of the main types of
derivatives above, check out CFI’s Introduction to Derivatives course!
• Derivates YouTube video