Ch 6: Credit Exposure Flashcards
(T or F) If the counterparty defaults shortly after the first payment is made, there could be a credit loss even if interest rates have not changed.
True
The receiver of a low-coupon currency has ___ credit exposure than the counterparty.
a. Less
b. Greater
b. Greater
- ___ involves settling the variation in the contract value on a regular basis
a. Margins and collateral
b. Marking to market
c. Exposure limits
d. Netting arrangements
b. Marking to market
If the Marking to market treatment is symmetrical across two counterparties, it is called ___. If one party settles losses, it is called ___.
two-way marking to market, one-way marking to market
(T or F) When positions are very large, the liquidation period is shorter compared to when postions are small.
false, larger positions = longer liquidation period
Marking to market introduces other types of risks. What are these risks?
- operational risk
- liquidity risk
___ represents cash or securities that must be advanced in order to open a position
- Margins
This margin serves as a performance bond to offset possible future losses should the customer default.
Initial Margin
(T or F) Margins are typically lower for hedgers because a loss on the futures position can be offset by a gain on the physical.
True
Over-the-counter markets may allow posting securities as ___ instead of cash, which protects against current and potential exposure.
Collateral
(T or F) With greater price volatility, there is an increasing chance of losses if the counterparty defaults and the collateral loses value, which decreases haircuts.
False, increases haircuts
Used to manage credit line usage for several maturity buckets
a. Exposure cap
b. Exposure profile
c. Margin
d. Haircut
b. Exposure profile
___ requires a payment to be made whenever the value of the contract exceeds some amount.
a. Margin
b. Collateral
c. Exposure cap
d. Haircut
c. Exposure cap
It refers to a clause in the contract requiring the contract to be marked to market at some fixed date.
a. Exposure
b. Netting Arangements
c. Wala na ko maisip
d. Recouponing
d. Recouponing
What is most powerful mechanism for controlling exposures?
Netting arrangements
The benefit from netting depends on the number of contracts N and the extent to which contract values covary. The smaller the value of N and the lower the correlation, the greater the benefit from netting.
false, the larger the value of N dapat
(T or F) Credit risk modifiers operate on credit exposure, default risk, or a combination of the two.
True
This specifies that if either counterparty’s credit rating falls below a specified level, the other party has the right to have the swap cash settled.
a. Time puts
b. Credit triggers
b. Credit triggers
It permits either counterparty to terminate unconditionally the transaction on one or more dates in the contract.
a. Time puts
b. Credit triggers
a. Time puts
Other term for Time puts?
Manual termination options
(T or F) Triggers and puts are two types of contigent requirements.
True
Which transaction does not result in a long-term credit risk for party A?
Example 1
a. Party A makes an unsecured loan to party B.
b. Party A is a fixed-price receiver in an interest rate swap from party B.
c. Party A buys a call option on September wheat from party B.
d. Party A sells a put option on the S&P 500 index to party B.
d. Party A sells a put option on the S&P 500 index to party B.
Your company has reached its credit limit to Ford, but Ford is insisting that your firm provide them some increased protection in the event a major project they are undertaking results in some unforeseen liability. Ignoring settlement risk and assuming option premiums are paid immediately at the time of the transaction, which of these strategies will not give rise to increased credit exposure to Ford?
Example 2
a. Selling a costless collar to Ford
b. Buying an option from Ford
c. Selling an option to Ford
d. None of the above
c. Selling an option to Ford
How does the credit exposure of a long OTC put option on XYZ stock change when the stock price decreases?
Example 3
a. It increases
b. It decreases
c. It does not vary with underlying stock price.
d. There is no credit exposure on long options.
a. It increases
If a counterparty defaults before maturity, which of the following situations will cause a credit loss?
Example 4
a. You are short euros in a one-year euro/USD forward FX contract, and the euro has appreciated.
b. You are short euros in a one-year euro/USD forward FX contract, and the euro has depreciated.
c. You sold a one-year OTC euro call option, and the euro has appreciated.
d. You sold a one-year OTC euro call option, and the euro has depreciated.
b. You are short euros in a one-year euro/USD forward FX contract, and the euro has depreciated.
___________________ is the largest and worst credit exposure at some level of confidence.
Worst Credit Exposure (WCE)
The ______________, increases the uncertainty in the interest rate
diffusion effect
The ______________, decreases the bond’s duration toward zero
Amortization Effect
- In determining the amount of credit risk in a derivatives transaction, which of the following factors are used?
Example 5
I. Notional principal amount of the underlying transaction
II. Current exposure
III. Potential exposure
IV. Peak exposure—the replacement cost in a worst-case scenario
a. I and II
b. I, III, and IV
c. III and IV
d. II, III, and IV
d. II, III, and IV
The credit exposure of an interest rate swap differs from that of a bond in that: The swap can be terminated by novation.The principal amount of the swap is not at risk. Swaps benefit from higher recovery rates. The full coupon amounts in the swap are not at risk.
Example 6
I and III
II and IV
II, III, and IV
I, II, III, and IV
a. I and III
B. II and IV
C. II, III, and IV
D. I, II, III, and IV
B. II and IV
Assume that swap rates are identical for all swap tenors. A swap dealer entered into a plain- vanilla swap one year ago as the receive-fixed party, when the price of the swap was 7%. Today, this swap dealer will face credit risk exposure from this swap only if the value of the swap for the dealer is
Example 7
a. Negative, which will occur if new swaps are being priced at 6%
b. Negative, which will occur if new swaps are being priced at 8%
c. Positive, which will occur if new swaps are being priced at 6%
d. Positive, which will occur if new swaps are being priced at 8%
c. Positive, which will occur if new swaps are being priced at 6%
Assume that the DV01 of an interest rate swap is proportional to its time to maturity (which at the initiation is equal to T). Assume that interest rate curve moves are parallel, stochastic with constant volatility, normally distributed, and independent. At what time will the maximum potential exposure be reached?
Example 8
a. T/4
b. T/3
c. T/2
d. 3T/4
b. T/3
Determine at what point in the future a derivatives portfolio will reach its maximum potential exposure. All the derivatives are on one underlying, which is assumed to move in a stochastic fashion (variance in the underlying’s value increases linearly with time passage). The derivatives portfolio’s sensitivity to the underlying is expected to drop off as (T − t)2, where T is the time from today until the last contract in the portfolio rolls off, and t is the time from today.
Example 9
a. T/5
b. T/3
c. T/2
d. None of the above
a. T/5
