Ch 6: Credit Exposure

Question 1

(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.

Answer 1

True

Question 2

The receiver of a low-coupon currency has ___ credit exposure than the counterparty.

a. Less
b. Greater

Answer 2

b. Greater

Question 3

4. ___ 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

Answer 3

b. Marking to market

Question 4

If the Marking to market treatment is symmetrical across two counterparties, it is called ___. If one party settles losses, it is called ___.

Answer 4

two-way marking to market, one-way marking to market

Question 5

(T or F) When positions are very large, the liquidation period is shorter compared to when postions are small.

Answer 5

false, larger positions = longer liquidation period

Question 6

Marking to market introduces other types of risks. What are these risks?

Answer 6

• operational risk
• liquidity risk

Question 7

___ represents cash or securities that must be advanced in order to open a position

Answer 7

• Margins

Question 8

This margin serves as a performance bond to offset possible future losses should the customer default.

Answer 8

Initial Margin

Question 9

(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.

Answer 9

True

Question 10

Over-the-counter markets may allow posting securities as ___ instead of cash, which protects against current and potential exposure.

Answer 10

Collateral

Question 11

(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.

Answer 11

False, increases haircuts

Question 12

Used to manage credit line usage for several maturity buckets

a. Exposure cap
b. Exposure profile
c. Margin
d. Haircut

Answer 12

b. Exposure profile

Question 13

___ requires a payment to be made whenever the value of the contract exceeds some amount.

a. Margin
b. Collateral
c. Exposure cap
d. Haircut

Answer 13

c. Exposure cap

Question 14

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

Answer 14

d. Recouponing

Question 15

What is most powerful mechanism for controlling exposures?

Answer 15

Netting arrangements

Question 16

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.

Answer 16

false, the larger the value of N dapat

Question 17

(T or F) Credit risk modifiers operate on credit exposure, default risk, or a combination of the two.

Answer 17

True

Question 18

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

Answer 18

b. Credit triggers

Question 19

It permits either counterparty to terminate unconditionally the transaction on one or more dates in the contract.

a. Time puts
b. Credit triggers

Answer 19

a. Time puts

Question 20

Other term for Time puts?

Answer 20

Manual termination options

Question 21

(T or F) Triggers and puts are two types of contigent requirements.

Answer 21

True

Question 22

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.

Answer 22

d. Party A sells a put option on the S&P 500 index to party B.

Question 23

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

Answer 23

c. Selling an option to Ford

Question 24

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.

Answer 24

a. It increases

Question 25

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.

Answer 25

b. You are short euros in a one-year euro/USD forward FX contract, and the euro has depreciated.

Question 26

___________________ is the largest and worst credit exposure at some level of confidence.

Answer 26

Worst Credit Exposure (WCE)

Question 27

The ______________, increases the uncertainty in the interest rate

Answer 27

diffusion effect

Question 28

The ______________, decreases the bond’s duration toward zero

Answer 28

Amortization Effect

Question 29

8. 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

Answer 29

d. II, III, and IV

Question 30

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

Answer 30

B. II and IV

Question 31

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%

Answer 31

c. Positive, which will occur if new swaps are being priced at 6%

Question 32

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

Answer 32

b. T/3

Question 33

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

Answer 33

a. T/5