Credit Risk in Derivatives Ravi Savur Vice President, Head – Structured Products +91 22 26535400 ravi.savur@citigroup.com November 25, 2003 Citibank N.A.

Legends about Derivatives

Legends about Derivatives Proctor & Gamble $120MM Orange County $35MM Gibson Greetings $20MM Metalgessellschaft DEM1.1BN Barings Bank $1.2BN Daiwa Bank $125MM Sumitomo Corp $100MM Kidder Peabody $350MM National Westminster Bank £90MM Union Bank of Switzerland $650MM Long Term Capital Management $3BN Enron $2BN Allied Irish Bank $750MM

Presentation Path Credit Risk in Derivatives Transaction and Portfolio Based Approaches Managing Credit Risk Legal and Documentation Appropriateness

Credit Risk What is Credit Risk? Risk of loss in the event of default by the counterparty What is at Risk? In a Loan Notional Amount In a Letter of Credit or other contingent obligation An amount up to the notional amount In a Derivative ?? Replacement cost

Approaches to Measuring Credit Exposure

BIS Norms for Credit Risk: 1988 (Sum of positive CMTM value plus sum of transaction credit add-on) x Counterparty Risk Weighting Residual Maturity <= 1 year > 1year Interest Rate 0.0% 0.5% Exchange Rate 1.0% 5.0% Counterparty Risk Weighting Government 0% OECD Bank 20% Other 50%

BIS Norms for Credit Risk: 1996 Expanded Matrix Residual Maturity < 1 year 1-5 years > 5 years Interest Rate 0.0% 0.5% 1.5% Exchange Rate 1.0% 5.0% 7.5% Equity 6.0% 8.0% 10.0% Precious Metals 7.0% 7.0% 8.0% Commodities 10.0% 12.0% 15.0%

Transaction based Credit Risk Measurement

How does a Derivative Work? Definition of a Swap An agreement to periodically exchange one interest payment for another interest payment (but set on a different mechanism) based on a notional principal amount. How is it Used? A fixed rate Issuer may move to floating (and/ or from currency 1 to currency 2) Moving from fixed to floating is equivalent to taking the view that rates will stay low (or will not rise as much as implied by the forward curve). If interest rates move, the swap will gain or lose value. Tier 2 Capital Investor Rupee interest Fixed rate Issuer Dollar Interest Floating Rate Rupee Interest Fixed rate

Interest Rate Swap Pricing

Calculation of Interest Rate Swap Rate Interest rate swaps are priced so that on the trade date, both sides of the transaction have equivalent NPVs. The fixed rate payer is expected to pay the same amount as the floating rate payer over the life of the interest rate swap, given the prevailing rate environment (where today’s forward curve lies). On the trade date, interest rate swaps can be thought of as an exchange of a fixed rate bond, for a floating rate bond.

Calculating Replacement Cost How Do Interest Rates Move? Random Walk theory Likens market movements to Brownian motion – the random movement of suspended particles in a colloidal solution. In Brownian motion, the distance of movement is proportional to the square root of time and this is the key to modeling market rate movements. For a given swap, and a given interest rate path, how much money will be owed to us What is the present value of that path at different points in time in the future.

Random Walk OIS Interest Rate 15% annual volatility assumed.

Cash Flows

Replacement Cost

PSE as a % of Notional

Measures of Credit Risk Pre-Settlement Exposure (PSE) The exposure when a counterparty becomes unable to settle its contractual obligations (“contracts”) prior to settlement and we therefore need to “replace” these contracts in the market. PSE on almost every derivative transaction. Various measurement concepts.

Transaction Based PSE Method For Each Contract: PSE = CMTM + MLIV MLIV = Notional * CEF CEF is measured: a) as the potential increase in the value of the contract b) Either averaged over the life of the contract or using the peak c) at a 99% confidence level d) using Random Walk e) for standard contracts, at the market f) using general market rates and volatilities g) ignoring any other contracts with the counterparty FOR THE PORTFOLIO: ADD CONTRACT PSEs

Problems with Transaction Approach Removes the relationship between potential exposure and time Averages are not additive. Peak exposures are not additive Assumes adverse move in the market factor. Credit exposure from both buys and sells. Cannot handle netting agreements

Portfolio Simulation Approach For the Portfolio: PSE is measured: a) as the potential increase in the value of the portfolio b) as a time varying risk over the life of the portfolio, with a peak risk at some point in time (not averaged) c) at the 99% confidence level d) using Monte Carlo simulation e) for the actual contracts in the portfolio f) using actual market rates, volatilities and correlations g) taking into account netting agreements and their effect RESULT: PSE PROFILE

Portfolio Simulation Results

Managing Credit Risk

Risk Mitigants Early Termination Options Bilateral or unilateral. Prices settled at mid or terminating party pays bid-offer spread. Each tenor slice must be greater than or equal to each subsequent tenor slice. Philosophy: Entering into the trade with the intention to terminate is not desirable. Counterparty's liquidity position should not be threatened in case it is necessary to make a payment under the early termination clause. Operations ability to highlight forthcoming early termination dates is critical.

Early Termination

Risk Mitigants (cont’d) Margining Under a margining agreement, a counterparty is required to post margin collateral periodically, based on the calculation of the net CMTM of the contracts (in the case of variation margin) or the potential exposure (initial margin) of the counterparty. Margining Parameters Threshold The amount of clean credit Minimum Transfer Amount The minimum amount of margin collateral to be posted (the 'Minimum Transfer Amount'), once the threshold level is reached. Frequency of Margining The time interval between margin calls, e.g., one day, one week, one month

Risk Mitigants (cont’d) Independent Amount / Initial Margin The counterparty may also be required to post an independent amount (or 'initial margin') at the initiation of a transaction Issues with Margining Perfecting interest in the collateral Operationally cumbersome

Margining

Legal and Documentation

Enforceability Questions surrounding Enforceability of Derivatives under Indian Law Section 30 of the Indian Contract Act makes wagers unenforceable A derivative, being dependent upon the outcome of an uncertain event, can be deemed a wager. Section 18 a of the Securities Contract Regulation Act allows for derivatives that are transacted on an Exchange and cleared through an Exchange. Derivatives under English Law are enforceable (Financial Services Act 1986). Will an Indian Court uphold the choice of English Law? Arbitration may help, in terms of quicker settlements, better understanding of transactions, and upholding the choice of law. The Reserve Bank of India and FIMMDA are seized of the matter.

What is a Master Agreement Governs multiple derivatives and/or FX transactions, all of which form a single agreement. Possible Master Agreements: ISDA, ICOM, IFEMA, FRABBA, etc. Advantages Standardised terms and conditions aid liquidity and certainty Reduce/eliminate any delay between commercial agreement and binding legal agreement Provides for exchange of separate confirmations on each transaction Drawbacks Legal risk: no documentation before dealing Can only be bilateral – cannot include subsidiaries companies, affiliates, etc. Suitability to non-standard transactions

Elements of an ISDA Master Agreement Fundamental obligations and mechanics Payment obligations Rate determinations Fundamental contractual and credit provisions Netting Representations (basic, tax) Warranties, undertakings Credit support provisions Events of default/termination Other contractual provisions Governing law Notices

Priorities ISDA Master Agreement applies Schedule to the ISDA Master Agreement overrides the Master Confirmation for a transaction overrides the Schedule. ISDA 2002 Master Agreement

Appropriateness