The Credit Risk of Complex Derivatives

During the 1970s and 1980s new financial derivatives were created by global financial intermediaries and exchanges as a means of permitting institutions to capitalize on, or protect against, movements in volatile market references; although derivatives had already existed in basic form for several decades, the market volatility present from the early 1970s onward¹ led to increased participation and innovation in these products. Among the most popular and innovative of the early derivatives (defined as financial contracts which derive their value from movement of underlying reference markets or securities) were standardized exchange-traded futures and options, which gained widespread acceptance during the 1970s, and basic over-the-counter forwards, swaps and options, which gained popularity during the 1980s. Most of the financial derivatives introduced in the 1970s and 1980s are common in the market-place of the 1990s and remain actively used by both end-users (investors and issuers which utilize the products for specific asset or liability purposes) and intermediaries (investment and commercial banks which create, package and trade the products); instruments such as futures (standard exchange contracts which enable participants to buy or sell an underlying asset at a predetermined forward price), forwards (customized off-exchange contracts which enable participants to buy or sell an underlying asset at a predetermined forward price), swaps (customized off-exchange contracts which enable participants to exchange periodic flows based on an underlying reference) and options (standard exchange or customized off-exchange contracts which grant the buyer the right, but not the obligation, to buy or sell an underlying asset at a predetermined strike price), are employed by issuers, investors and financial intermediaries on a routine basis to achieve specific risk management or investment goals.

In any business it is necessary to classify, measure and manage accurately variables which represent uncertainty, or risk, to the normal functioning of operations. This is especially true in the banking industry, where the essence of the business is to reward an institution for risks taken and managed. The effective management of risks is typically accomplished through a risk management framework where an institution identifies, classifies, measures and manages the different risks inherent in its line of businesses. Knowledge of risks affecting a given business allows losses to be controlled or avoided and profits to be maximized.

Over-the-counter options can be bought and sold on any instrument and can be constructed to provide virtually any type of payoff or protection profile; as such, options are often considered the fundamental building blocks of custom derivative packages. Given the importance of options in the financial markets we develop, in this chapter, an REE method for estimating credit risk in standard option contracts; equations developed in this chapter are applied to option products and strategies analyzed in Chapters 4, 5 and 7.

An institution active in listed or over-the-counter options for investment or risk management purposes often utilizes more than simple put or call positions to implement a given strategy; depending on the results it is attempting to achieve, it may use options in combinations which yield specific payoff or protection profiles not attainable through simple positions. In the previous chapter we have discussed the credit risk of standard put and call transactions. In this chapter we expand the discussion by exploring the credit risk of compound option strategies.

In Chapter 3 we have reviewed methods of quantifying the risk of standard put and call options and in Chapter 4 we have discussed the nature and risk of various compound option strategies. In this chapter we explore the nature, use and risk of complex options; while such options were regarded as rather esoteric only a few years ago, most are becoming increasingly commonplace in today’s financial markets. Complex options are defined as derivatives with structural enhancements which result in payoff or protection profiles which are different from those obtained with vanilla puts and calls; the structural differences can relate to the nature and determination of the payoff path, the commencement of the option, the timing of the premium payment, the establishment of the strike price, and so on. Given the differences between vanilla and complex options many of the risk features are distinct from those discussed in the previous chapter and warrant closer examination. Indeed, certain derivatives described in this chapter carry substantial amounts of credit risk; credit officers evaluating the appropriateness of such deals must be fully aware of the credit exposures assumed when executing such transactions.

The calculation of swap credit risk exposure continues to be an important topic of discussion at financial institutions and regulatory agencies around the world. Given the complexity of estimating the credit risk of financial contracts whose value changes on a continuous basis, there is no universally accepted fashion by which to assign credit risk exposure to swap transactions; much is dependent on the views of regulators and individual institutions. There are, in general, two broad approaches which must be considered: the calculation of risk exposure for regulatory purposes and the calculation of risk exposure for internal measurement and management purposes. In certain instances these approaches may be identical, particularly if an institution falls under a regulatory jurisdiction which enforces a particular methodology and prefers to apply the same regulatory guidelines to its internal management process. In other instances the approaches may be different; this occurs when there is no governing regulatory guideline or when an institution prefers to utilize regulatory risk calculations for regulatory capital and reporting purposes, and internal risk calculations for internal credit allocation, credit pricing, and risk-adjusted performance purposes. In this chapter we discuss both approaches in general terms (saving a more detailed review of a sample methodology for discussion in Appendix 2). Various concepts developed in this chapter are applied in our discussion of complex swap products in Chapter 7.

In Chapter 6 we have described in overview various methods of quantifying risk in standard swap structures (i.e. those which involve the periodic exchange of flows between two parties). While generic swaps are by now well established in the financial markets, there are various complex swap structures which are receiving increased attention and use by financial and corporate participants; in this chapter we describe and analyze a variety of these instruments. Note that while in past chapters we have described derivative structures generically (capable of use in a broad range of underlying markets), in this chapter we are required to narrow our discussion slightly and analyze complex swaps in terms of the markets in which they are normally used; not all swap structures are applicable to all underlying reference markets. The specific swaps which we describe and analyze below include inverse floater swaps, leveraged swaps, differential swaps, amortizing swaps, mortgage swaps, and index principal swaps/reverse index principal swaps (which are utilized primarily in the interest rate and/or currency markets), credit swaps (including credit forwards, default swaps and total return swaps) (which are utilized in the credit markets), and equity-index swaps (which are used in the equity markets). We shall not discuss other ‘non-standard’ structures such as putable and callable swaps, forward swaps, premium-discount swaps or zero coupon swaps, as these have been described in a previous volume (see Banks, 1993). In the first section of this chapter we provide product description on each derivative and in the second section we discuss the credit risk quantification of these instruments.

The ongoing management of derivative credit exposures represents an integral component of the risk control framework; once an institution identifies and quantifies its credit risk exposures it needs to ensure they are actively and appropriately managed. While risk identification and measurement, which we have discussed at length in Parts II and III, are critical elements of the entire process, it is the continuous risk management of credit exposures which permits a financial institution to control its derivatives business most effectively, and accurately, on an ongoing basis.

In Parts II and III of this text we have introduced fundamental methods for identifying and quantifying the credit risk of various derivative structures, and in the previous chapter we have discussed various techniques for quantifying derivative credit exposure on a portfolio basis; in this chapter we address a number of qualitative issues related to the management of derivative portfolios. In the first section below we explore the dynamic management of derivative exposures, which is most often accomplished through credit risk mitigation techniques, credit risk simulations/scenario analyses, and dynamic limit adjustment; such dynamic risk management is generally monitored through a comprehensive credit system infrastructure. In the second section of the chapter we consider a range of ancillary credit risk management issues which analysts are increasingly required to address; these topics include counterparty motivation for entering into derivative transactions (and the suitability of entering into such transactions), relevance of credit analysis in an era of lengthening transaction maturities, and problems posed by a counterparty’s unwillingness to perform on its derivative obligations (rather than its financial inability to perform on such obligations, which is the domain of traditional credit analysis). The quantitative aspects of credit risk management presented in Chapter 8 and the qualitative aspects presented in this chapter combine to form an overall framework for the ongoing management of derivative credit risk exposures.