For instruments that trade and are re-priced on a daily basis we need to consider the interaction of credit risk (a counterparty default) and price risk (the risk that the market has moved against us).

What happens when a counter party defaults on settlement when

1. He has to deliver a bond that you have purchased and
   1. bond prices have moved downwards
   2. bond prices have moved upwards

       

2. He has to take delivery of a bond that you have sold and
   1. bond prices have moved downwards
   2. bond prices have moved upwards

    

3. Do we have the same exposure on a derivative contract? Interest Rate Swaps and Cross Currency Swaps
4. He has to deliver Euros that we have purchased and
   1. US$/Euro Exchange rate has appreciated in favor of Euro
   2. US$/Euro Exchange rate has appreciated in favor of US$

    

5. Do we have the same exposure on option contract?

    

6. How do we calculate Potential Future Exposure?

Counterparty Limits – Measuring Exposure

Counterparty limit setting process can be broken down into two categories.

The first is the Financial Institution (FI) limit setting process which is dealt with through the FI function.

The second is a customer limit which is treated and calculated in the same manner as allocation of credit to corporate customers.

The FI limit setting process entails setting limits depending on:

• Issuer’s credit rating (limits set on issuer based on credit rating)
• Analysis of its financial health and strength, including capital adequacy, asset quality, earnings/ profitability, liquidity position, cash flow generation capacity, liquidity, ratios (limits set based on acceptable levels for financial ratios).
• Institution profiles, such as the history, nature of business, types of business, product offerings, branch network and compliance with KYC (limits set based on acceptable benchmarks for each characteristic)

The FI limit setting process may also be product specific.

For a corporate customer, especially on derivative contracts, the primary question on a given transaction is Potential Future Exposure. How much money can the bank lose if the customer defaults on settlement? And is there anything the bank can do to secure that exposure?