Can someone please verify this for me? In a swap, even if the current credit risk is zero, there’s potential credit risk since there’s time left until settlement date. Am I correct to say that as long as it’s before the settlement date, there will ALWAYS be potential credit risk? (Schweser V1, E2, Q14.3).
my answer would be yes.
I think potential credit risk is equal to the market value of the swap. If its market value is positive and equal x, you have potential credit risk equal to x. Your counterparty has no potential credit risk. If the market value is negative, your counterparty has the potential credit risk.
^Agreed. Potential credit risk is basically the amount of the claim that the positive value party would have it the counterparty defaulted. That amount is the difference between the PV (fixed PMTs) and PV(float PMTS). So at initiation and anytime the values net out, you would have to say that potential credit risk is zero. But in cases where notional principal is exchanged, this may be a different story…
maratikus Wrote: ------------------------------------------------------- > I think potential credit risk is equal to the > market value of the swap. If its market value is > positive and equal x, you have potential credit > risk equal to x. Your counterparty has no > potential credit risk. If the market value is > negative, your counterparty has the potential > credit risk. This is EXACTLY what I thought too, before this question from Schweser (unless I’m misinterpreting what they’re saying). In the question the current credit risk was zero because the sawp contract price was 50 and it’s currently priced at 50 with six month until expiration. The answer states, “Current credit risk refers to the amount due now and there is none. However, the forward contract has positive value to the long of $50 minus the present value of $50, so there is potential credit risk in that amount.” Am I missing something? How does any party have positive value right now?
McLeod81 Wrote: ------------------------------------------------------- > ^Agreed. Potential credit risk is basically the > amount of the claim that the positive value party > would have it the counterparty defaulted. That > amount is the difference between the PV (fixed > PMTs) and PV(float PMTS). So at initiation and > anytime the values net out, you would have to say > that potential credit risk is zero. > > But in cases where notional principal is > exchanged, this may be a different story… To your point, McLeod81, there were no funds exchanged upfront.
Am I reading this wrong or are we saying the same thing in a roundabout way Interest rate swaps, credit risk is highest somewhere around the middle of the swap’s life and decreases as time passes and number of remaining settlement periods decrease Currency swaps, both parties are simultaneoulsy exposed to credit risk which is increased due to exchange of principal at inception and maturity of swap. Credit risk is highest between the middle and maturity of the swap. The above leads me to believe that there is always potential credit risk.
Potential Credit Risk of a swap (receive fixed) = PV(Fixed PMT) - PV(Float PMT) If no principal is exchanged, and PV(Fixed) = PV(Float), your potential credit risk has to be zero. If principal WAS exchanged, I would say that it should go something like: Potential Credit Risk = PV(Fixed PMTs) - PV(Float PMTs) + PV(Notional Principal) -because if the other party defaults, you’re also lose out on the PV of the NP
Here is the question verbatim: Relevant fact pattern: A forward contract sold by Palmer Securities has six months until the delivery date and a contract price of 50. The underlying asset has no cash flows or storage costs and is currently priced at 50. In the contract, no funds were exchanged upfront. Question: Determine whether the forward contracts sold by Palmer Securities have current and/or potential credit risk. A. The contract has current credit risk only. B. The contract has potential credit risk only. C. The contract has neither potential credit risk nor current credit risk.
The current credit risk is the risk that a payment due now (ie current) is not paid. Potential credit risk is the risk that future payments which will be payable due to passage of time are not made. In the question there is no payment due at the current time so current credit risk =0. The future is in the money to one party though so that party bears potential credit risk. To answer passthismofo’s qn: there won’t always be potential credit risk. If the currentvalue of future was nil then neither party would be in the money and potential credit risk is 0. Edit to put it another way potential risk is NOT the maximum credit risk ever potentially due which is infinite. Hope this isn’t too wordy.
McLeod and Hurricane, thanks for this clarification. So the answer to ook’s question above would be C then.
ook Wrote: ------------------------------------------------------- > Here is the question verbatim: > > Relevant fact pattern: > A forward contract sold by Palmer Securities has > six months until the delivery date and a contract > price of 50. The underlying asset has no cash > flows or storage costs and is currently priced at > 50. In the contract, no funds were exchanged > upfront. > > Question: > Determine whether the forward contracts sold by > Palmer Securities have current and/or potential > credit risk. > A. The contract has current credit risk only. > B. The contract has potential credit risk only. > C. The contract has neither potential credit risk > nor current credit risk. Long contract value = 50-50/(1+rfr)^T > 0 -> short < 0 -> no potential credit risk. No current credit risk either because there are no payments due short-term. C is the answer.
Agree with maratikus. You have to bring both numbers to PV.