Book 2. Credit Risk

FRM Part 2

CR 14. Derivatives

Presented by: Sudhanshu

Module 1. Types of Derivatives and Derivatives Markets

Module 2. Central Clearing of Derivatives and Modeling Derivatives Risks

Module 1. Types of Derivatives and Derivatives Markets

Topic 1. Introduction to Derivatives

Topic 2. Derivatives Markets

Topic 3. Clearing Derivatives Transactions

Topic 4. Market Participants and Collateralization

Topic 1. Introduction to Derivatives

• Definition: A derivative is a financial contract whose value is derived from an underlying asset, group of assets, or benchmark. Unlike traditional securities like stocks or bonds, a derivative itself has no intrinsic value; its worth is entirely dependent on the value of something else.

• Purpose: The primary purpose of derivatives is to transfer risk. They are used by market participants for two main reasons:

  • Hedging: To mitigate or reduce risk. For example, an airline might use a jet fuel futures contract to lock in a price and protect itself from a sudden increase in fuel costs.

  • Speculation: To take on risk in the hope of profiting from price movements. A speculator who believes the price of a stock will rise might buy a call option on that stock.

• Key Risk: While derivatives can be used to manage market risks, they introduce a new risk: counterparty credit risk. This is the risk that the other party to the contract will not fulfill its obligations, leading to a potential loss for you.

Topic 2. Derivatives Markets

• Exchange-Traded Derivatives:

  • Description: Standardized contracts with predetermined specifications, such as size, expiration date, and quality of the underlying asset, that trade on a regulated exchange. Examples include futures contracts and most options contracts.

  • Key Characteristics:

    • Standardized: The terms of the contract are set by the exchange, not the counterparties. This makes them highly fungible.

    • Highly Liquid: Standardization and a central marketplace ensure there are always willing buyers and sellers.

    • Transparent: All prices and trading activity are publicly available, providing real-time market data.

    • Centrally Cleared: A Central Counterparty (CCP) guarantees the performance of the contract, effectively eliminating counterparty risk for market participants.

• Over-the-Counter (OTC) Derivatives:

  • Description: Private, customized contracts negotiated and traded directly between two parties. Examples include swaps, forwards, and customized options.

  • Key Characteristics:

    • Customizable: The contract terms can be tailored to meet the specific needs of the counterparties.

    • Less Liquid: Since contracts are customized, finding an offsetting counterparty can be difficult, making them less liquid than exchange-traded derivatives.

    • Less Transparent: Pricing and trading information are not publicly disclosed, making it a more opaque market.

    • Counterparty Risk: Without a CCP, the parties face the risk that their direct counterparty will default. This risk is typically managed through master agreements and collateralization.

Topic 2. Derivatives Markets

Topic 3. Clearing Derivatives Transactions

• Clearing: The process of managing a transaction from the time a trade is made until it is settled. It involves functions such as trade confirmation, netting of obligations, and risk management through margining. This process is crucial for ensuring the integrity of the financial system.

• Settlement: The final step where money and/or securities are exchanged to fulfill legal obligations. Clearing ensures that settlement occurs smoothly and without default.

• Bilateral Markets:

  • Description: The original counterparties remain unchanged, and each party is directly responsible for managing its own counterparty risk.

  • Risk: This model is susceptible to "walk-away risk," where a counterparty might default on its obligations, leaving the solvent party with a loss.

• Centrally Cleared Markets:

  • Description: A Central Counterparty (CCP) steps in as the new counterparty to both sides of the transaction. The CCP becomes the buyer for every seller and the seller for every buyer.

• Risk Mitigation: By interposing itself between the original counterparties, the CCP effectively removes bilateral counterparty risk and replaces it with the single, well-capitalized risk of the CCP. This is considered the most effective way to reduce counterparty risk.

• Mandates: Post-financial crisis, many regulators have mandated central clearing for a wide range of standardized OTC derivatives to enhance market stability.

Topic 3. Clearing Derivatives Transactions

Topic 4. Market Participants and Collateralization

• Market Participants:

  • Major Dealers: Global banks and financial institutions that actively trade and make markets in derivatives. They have a significant amount of exposure and rely on internal models and master agreements to manage their risk.

  • Medium-Sized Players: Regional banks and other financial institutions that use derivatives for risk management or proprietary trading.

  • End Users: Non-financial corporations, pension funds, hedge funds, and governments that use derivatives to hedge specific risks (e.g., interest rate risk on debt, foreign exchange risk on international operations).

• Collateralization:

  • Purpose: Collateral is a crucial tool for mitigating counterparty credit risk. It serves as a form of security to ensure that an outstanding obligation is settled even if a counterparty defaults.

  • Exchange-Traded & Centrally Cleared OTC: These are always collateralized. The CCP manages the collateralization process by requiring both initial margin and variation margin from its members.

  • OTC Collateralized: Bilateral trades where both parties post collateral with each other based on the value of the positions. This is a common practice to reduce exposure.

• OTC Uncollateralized: Bilateral trades without collateral. These transactions pose the highest counterparty risk and are increasingly rare due to regulatory pressure and market standards.

• Collateral Agreements:

  • Credit Support Annex (CSA): This is a key part of the ISDA Master Agreement. It specifies the terms for posting collateral, including the types of collateral accepted (e.g., cash, government bonds), the frequency of margin calls, and the minimum transfer amount. A CSA is essential for collateralized OTC trades.

Topic 4. Market Participants and Collateralization

Practice Questions: Q1

Q1. The process under which margin transactions are facilitated and computed is best referred to as:
A. clearing.
B. settlement.
C. execution.
D. collateralization.

Practice Questions: Q1 Answer

Explanation: A is correct.

Clearing is the process of recording counterparties’ identities and calculating
margin and payment obligations. Settlement is the process of facilitating payment and transferring money when the contract is closed out. Execution is the initial step of entering into a derivatives contract. Collateralization is the process of posting assets as security to minimize credit risk.

Module 2. Central Clearing of Derivatives and Modeling Derivatives Risks

Topic 1. ISDA Master Agreement

Topic 2. Credit Derivatives

Topic 3. Central Counterparties (CCPs)

Topic 4. Margin Requirements for Derivatives

Topic 5. Counterparty Risk Intermediaries

Topic 6. Modeling Derivatives Risk

Topic 1. ISDA Master Agreement

• Purpose: A standardized legal document published by the International Swaps and Derivatives Association (ISDA). It's the cornerstone of OTC derivatives, providing a common legal and contractual framework for trades between two parties. The core purpose is to simplify and reduce legal risks by establishing a single agreement that governs all transactions between two counterparties.

• Key Features:

  • Netting: The most critical function. It allows for closeout netting, meaning in the event of a default, all outstanding transactions between the two parties are terminated and a single, net payment is calculated. This prevents a situation where the solvent counterparty would have to pay on its winning trades while losing out on its defaulting counterparty's trades.

  • Events of Default: The agreement explicitly defines what constitutes a "default," such as failure to pay, bankruptcy, or a breach of the agreement.

  • Termination Events: It also specifies other events, like a change in law or illegality, that can lead to the termination of the contract.

  • Standardized Definitions: It provides consistent definitions for terms like interest rates, currencies, and payment schedules, which reduces ambiguity and legal disputes.

Topic 2. Credit Derivatives

• Definition: Derivatives designed to hedge exposure to credit risk. They allow for the transfer of credit risk from one party to another without the underlying asset changing hands.

• Most Common Types:

  • Credit Default Swap (CDS): This is the most prevalent type. A protection buyer pays a periodic fee (like an insurance premium) to a protection seller. In return, the seller agrees to pay the buyer the par value of a reference debt obligation if a "credit event" occurs (e.g., bankruptcy, failure to pay).

  • Total Return Swap (TRS): The two parties agree to exchange a periodic interest payment (usually a floating rate) for the total return on a reference asset. The total return includes both the interest payments and any change in the asset's value.

  • Credit Linked Note (CLN): This is a structured note with an embedded credit default swap. If a specified credit event occurs, the investor (who bought the note) can lose some or all of their principal.

• Inherent Risk: While credit derivatives are designed to manage credit risk on an underlying asset, they introduce credit risk between the two counterparties to the derivative contract itself. This is why collateralization and central clearing are important for these instruments.

Topic 3. Central Counterparties (CCPs)

• Role: CCPs provide clearing services and stand between counterparties, becoming the buyer for every seller and the seller for every buyer. They are crucial for systemic risk mitigation, especially after the 2007-2009 financial crisis.

• Key Functions:

  • Multilateral Netting: CCPs net all buy-side transactions with sell-side transactions, which significantly reduces the total number of open positions and the overall risk in the system.

  • Loss Mutualization: In the event of a default, losses are spread across all clearing members through a default fund, rather than being borne by a single counterparty.

  • Default Management: CCPs have a plan to manage the positions of a defaulting member, including closing them out in an orderly fashion.

  • Margin Requirements: They require members to post initial and variation margin to cover potential losses

• Advantages:

  • Significant reduction of counterparty credit risk: By stepping in as the new counterparty, the CCP effectively eliminates the original counterparty risk.

  • Improved operational efficiency: The standardized process reduces the complexity of managing multiple bilateral trades.

  • Reduced systemic risk: By mutualizing losses and managing defaults, CCPs prevent a single failure from triggering a cascade of failures across the financial system.

• Shortfalls: A CCP failure could cause a systemic shock. Furthermore, because CCPs prioritize derivatives counterparties, this could be at the expense of other market participants like bondholders.

Topic 3. Central Counterparties (CCPs)

Topic 4. Margin Requirements for Derivatives

• Initial Margin: This is collateral posted at the start of a transaction to cover the potential future exposure of a position. It is a one-time payment made by a participant to the CCP to cover potential losses in the event of a default. The amount is determined based on the size of the position and its volatility.

• Variation Margin: This collateral is exchanged daily to cover changes in the market value of a position. It's used to settle the daily gains and losses on a derivatives contract. If a position's value increases, the counterparty receives variation margin; if it decreases, they must post more. This process helps prevent a buildup of large counterparty exposures.

• Centrally Cleared vs. Non-Centrally Cleared:

  • Centrally Cleared Derivatives: Require both initial margin and variation margin. This two-tiered system is a core component of the CCP's risk management framework.

  • Non-Centrally Cleared Derivatives: Historically had limited margin requirements, but global regulators (like those implementing Basel III) are increasingly introducing mandatory margin rules for these transactions to reduce systemic risk.

Topic 5. Counterparty Risk Intermediaries

• Special Purpose Vehicles (SPVs): An off-balance-sheet, bankruptcy-remote entity separate from its sponsor, created to reduce counterparty risk. It isolates the originator from counterparty risk by making SPV investors a priority as creditors. However, there is a significant legal risk that a bankruptcy court could consolidate the SPV's assets with the sponsor's in a default, undermining its purpose.

• Derivatives Product Companies (DPCs): An entity set up by a financial institution to obtain a very high credit rating (typically AAA) with separate capitalization from the parent. DPCs often remain market-neutral by trading offsetting contracts. They are designed to be bankruptcy-remote, but their orderly unwinding can be challenging in a financial crisis, as seen with Lehman Brothers and Bear Stearns.

• Monoline Insurance Companies: Highly leveraged insurance companies with a single business line: to insure bond repayments (credit wraps). They offer credit enhancements, often in the form of CDSs, and don't typically post collateral in normal conditions. During the global financial crisis, many monolines lost their high ratings and failed when forced to post collateral as insured losses mounted.

• Credit Derivatives Product Companies (CDPCs): Similar to DPCs but with a business model like monolines. They provide credit derivative protection and profit from it. They are highly leveraged and don't use offsetting risk positions, which makes them highly susceptible to market risk. Similar to monolines, many failed during or after the global financial crisis.

• Limitations: While these intermediaries were created to mitigate counterparty risk, they all have significant limitations, including legal, market, and operational risks, which were exposed during the 2007-2009 financial crisis.

Topic 5. Counterparty Risk Intermediaries

Topic 6. Modeling Derivatives Risk

• Value at Risk (VaR): This is a statistical measure used to estimate the maximum potential loss that a portfolio could experience over a specified time horizon with a certain probability (e.g., 95% or 99%).

  • Example: A fund's one-week VaR is $1 million at a 95% probability. This means that, based on historical data, there is a 5% chance that the fund will lose more than $1 million over a one-week period. It's important to note that VaR does not predict the worst-case scenario; it only provides a probability-based estimate.

  • Strengths: Widely used and understood, provides a single number to represent risk.

  • Weaknesses: It does not capture "tail risk" (the losses beyond the confidence level), and its assumptions about asset correlations can break down during times of market stress.

• Potential Future Exposure (PFE): This is a measure of a counterparty's credit risk over a long time horizon. It estimates the maximum potential exposure a party could have to a counterparty at any point in the future over the life of a derivative contract. It differs from VaR in that it is a measure of exposure to a single counterparty, rather than a total portfolio loss.

• Expected Shortfall (ES): Also known as Conditional VaR (CVaR), this measure is a more robust alternative to VaR. It calculates the average loss that would occur in the worst-case scenarios, specifically the average loss that would be experienced if the loss exceeds the VaR level.

• Strengths: Addresses the main weakness of VaR by providing a measure of "tail risk," giving a better picture of potential losses in extreme market events.

• Challenges:

  • Model Risk: The models rely on historical data and statistical assumptions that may not hold true in future, especially during periods of market stress. For example, correlations between assets can increase significantly in a crisis, which could lead to much higher losses than a model would predict.

  • Input Data: The quality and accuracy of the model outputs are highly dependent on the quality of the input data.

  • Behavioral Changes: Market participant behavior can change in a crisis, leading to unexpected outcomes that models may not capture.

  • Qualitative Judgment: Models should not be used in isolation. Risk managers must combine the model output with their own qualitative judgment and stress testing to get a complete picture of the risk.

Topic 6. Modeling Derivatives Risk

Practice Questions: Q1

Q1. Which of the following statements is not an improvement that centrally cleared markets offer relative to bilateral markets? Centrally cleared markets:
A. remain market neutral by netting trades.
B. offer more flexibility in contract selection.
C. formalize the default closeout process by mutualizing losses.
D. improve counterparty risk by replacing the original counterparty with a series of new counterparties.

Practice Questions: Q1 Answer

Explanation: B is correct.

Bilateral markets permit any type of customized financial contract and customized collateral that is freely negotiated between the two bilateral parties. In a centrally cleared market, flexibility is reduced because contracts must be standardized, and collateral rules are fixed and nonnegotiable.

Practice Questions: Q2

Q2. Which of the following actions is not an advantage of the central counterparty (CCP) in the centralized clearing process?
A. Loss mutualization.
B. Eliminate counterparty risk.
C. Improve operational efficiency.
D. Risk reduction through multilateral nettng.

Practice Questions: Q2 Answer

Explanation: B is correct.

The centralized clearing process used by a CCP does not fully eliminate counterparty risk, but it significantly reduces or minimizes this risk relative to bilateral transactions.

Practice Questions: Q3

Q3. Which of the following statements is an enhancement offered by the central counterparty (CCP) structure relative to the special purpose vehicle (SPV), the derivative product company (DPC), and the monoline insurance models? The CCP structure:
A. enables financial institutions to remove assets from their balance sheets.
B. enables counterparty risk to be outsourced, but in a non diversified format.
C. spreads losses over a group of counterparties to minimize potential systemic risk.
D. enables a counterparty transaction originator to fail and not affect the other member firms.

Practice Questions: Q3 Answer

Explanation: C is correct.

Through the collateralization and loss mutualization processes, a CCP spreads losses over a group of counterparties—and, in the process, reduces potential systemic risk. SPVs and DPCs are entities that remove assets from a financial institution’s balance sheet. Mono lines enable counterparty risk outsourcing in a non diversified format. In the event that a member fails in the CCP structure, all other member firms are impacted through loss mutualization. It is the DPC that protects itself from the failure of the transaction originator.

Practice Questions: Q4

Q4. A risk manager at MAB Funds estimates that the fund’s one-week value at risk (VaR) is $1 million using a 95% probability. The fund can, therefore, be expected to lose:
A. an average of $1 million in a week 5% of the time.
B. an average of $1 million in a week 95% of the time.

C. no more than $1 million in a week 5% of the time.
D. no more than $1 million in a week 95% of the time.

Practice Questions: Q4 Answer

Explanation: D is correct.

VaR measures the worst loss over a specified short period using a given confidence level. As a result, the risk manager expects that the fund will lose no more than $1 million in a week 95% of the time (or, it will lose at least $1million 5% of the time).