Current Credit Exposure

[atandon]

Hi David, I am referring to a question from last year doc - T3.Hull-Chapter-7 (Page 12)

177.3. Company A, the fixed-rate payer, enters into an interest rate swap with Company B, the floating-rate payer. Company will pay 4.0% per annum in exchange for six-month LIBOR, with an exchange every six months. The swap rate term structure is upward- sloping; for example, the 6-month swap rate is 1.0% and the five-year swap rate is 7.0%. Consider the following statements:
I. At swap inception, the market value of the swap is zero to both counterparties
II. After the first netted payment (coupon) exchange, in six months, the current credit exposure will be zero to both counterparties
III. The expected credit exposure, at the end of the first year, will necessarily be positive for one counterparty and negative for the other

Extracted the part of the answer below which I want to clarify -

In regard to (II), it is tempting to think true and this would be true if the term structure were flat. But, an upward sloping term structure, to settle an initial swap value of zero again fixed 6% coupons, implies smaller floating coupons in the early phase and greater floating coupons in the later phase; i.e., implied by an upward sloping FORWARD rate curve). So, the swap anticipates that (for example) the first exchange will net a positive cash flow to the floating-rate payer. In this case, the fixed-rate payer has positive credit exposure.

Could you explain the Part-II more pls? When both parties do a net settlement on the 1st period(6 months), net exposure should be zero because no party is holding anything and principal is not exchanged in IRS. So how will it matter for term structure to be upward sloping or flat?

Thanks,
atandon

 

[David Harper CFA FRM]

Hi atandon,

If the swap is initially fair (value = 0 at inception), under an upward-sloping term structure, the floating rate payer expects to pay lowers coupon in the early maturities and higher coupons in later maturities; e.g., against a 4% fixed, early floating coupons < 4% and later > 4%. Therefore, the first swap will settle with positive cash flow to the floating-rate payer/fixed-receiver, and the floating-rate receiver/fixed-rate payer will "out of pocket" (not out of the money!) and credit exposure.
... it's very difficult, i think because the basic rule is that a gain in the value creates credit exposure; e.g., as a counterparty moves in-the-money (value gain) they incur positive counterparty credit exposure.
... however this scenario (which I sourced from the handbook; GARP has a way of sometimes testing off the assigned material!) does not require interest rates to drop such that the floating-rate receiver gains and incurs credit exposure, only that the "fair swap" incorporate an upward sloping spot/forward interest rate curve

In summary, we can different two sources of counterparty credit exposure for the fixed-rate payer/floating-rate receiver:

1. Interest rates increase; i.e., gain in value
2. Pattern of cash flow receipts; i.e., upward sloping structure implies receipts are back-loaded

I hope that helps, thanks,

 

[atandon]

Thank You.

 

[jakub]

Hi David,
Regarding question 176.4, if Bank B pays interest on EUR 70m it means that it received 70m from bank A and paid USD 100m. I would assume that Bank B's exposure is 2m. Your explanation suggests otherwise. Could you clarify.

Regards,
Jakub

 

[David Harper CFA FRM]

Hi Jakub,

The PDF, I think contains an error. Can you look at the comment here @ http://forum.bionicturtle.com/threads/l1-t3-176-currency-swap-valuation.4587/#post-12140
... I think my correction comports probably comports with your view. Apologies for the confusion ... thanks!