Ch 5 - Dynamic Credit Exposure

Question 1

What is Dynamic Credit Exposure?

Answer 1

Credit exposure is not fixed, it fluctuates with the value of the underlying product.
There is a difference between the predetermined conditions and the prevailing ones at the time of the expected payment on sale/purchase
-Are commonly financial instruments such as FX, interest rates or equities etc
-Long tenor
-Often no exchange of cash or goods up front
-Both parties commit to make a payment in the future

Question 2

Comparison of Long-term Supply Agreement and Call option (figure 5.2 pp 67)

Answer 2

• Utility corp enters into a long-term contract with Traders: UC will buy a predetermined amount from TC for a set price over a time, in exchange for commitment to be delivered a given qty of oil
• At some point, the price of oil goes up. UC made the contract with TC for $3 a gallon, however the price has risen to $4.
• This is good for UC, however it causes TC to go out of business, which means UC must abandon the contract and find another supplier
• The loss for UC is the difference ($1) times the qty times the time remaining on the contract

Question 3

What creates the Dynamic Exposure in the Call Option example?

Answer 3

The magnitude of the credit exposure depends on the market price at the time of default. Each time the price of the product underlying the agreement changes, the credit exposure changes.

Question 4

Value at Risk (VaR)

Answer 4

The range of the future credit exposure can be estimated statistically, and the outcome is a probability-weighted distribution of exposures from which the VaR can be extracted. The VaR is the GE attached to a transaction generating a dynamic credit exposure

Question 5

VaR (2)

Answer 5

• What is the likelihood that the price reaches a certain level and, if so, what is the corresponding MTM value of the contract?
• MTM values based on historical data are more or less normally distributed, with the area below the curve representing the probability associated with all possible outcome scenarios

Question 6

Why is Value at Risk (VAR) a critical tool for a credit risk manager?

Answer 6

Risk managers are most interested in the tail of the distribution, since values in these areas correspond to unfavourable outcomes.
E.g. a point at the tail of the distribution may correspond to the 99% probability of MTM values being at or below $100m (i.e. only 1% chance that exposure on the counterparty on this contract will be more than $100m)