1. Credit Risk in Derivatives
Ravi Savur
Vice President, Head – Structured Products
November 25, 2003
Citibank N.A.

2. Legends about Derivatives

3. 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

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

5. 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

6. Approaches to Measuring Credit Exposure

7. 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%

8. 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%

9. Transaction based Credit Risk Measurement

10. 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

11. Interest Rate Swap Pricing

12. 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.

13. 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.

14. Random Walk OIS Interest Rate
15% annual volatility assumed.

15. Cash Flows

16. Replacement Cost

17. PSE as a % of Notional

18. 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.

19. 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

20. 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

21. 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

22. Portfolio Simulation Results

23. Managing Credit Risk

24. 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.

25. Early Termination

26. 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

27. 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

28. Margining

29. Legal and Documentation

30. 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.

31. 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

32. 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

33. 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

34. Appropriateness