Credit Exposure on Derivative Contracts
The credit exposure on any contract represents what the bank stands to lose—in its own currency—in the event of counterparty default..
Credit risk is the probability of a financial loss resulting from a borrower's failure to repay a loan.
Essentially, credit risk refers to the risk that a lender may not receive the owed principal and interest, which results in an interruption of cash flows and increased costs for collection..
One of the risks of a credit default swap is that the buyer may default on the contract, thereby denying the seller the expected revenue.
The seller transfers the CDS to another party as a form of protection against risk, but it may lead to default..
Among the most common derivatives traded are futures, options, contracts for difference (CFDs), and swaps.
This article will cover derivatives risk at a glance, going through the primary risks associated with derivatives: market risk, counterparty risk, liquidity risk, and interconnection risk..
Credit risk (also called counterparty risk) can be defined as the loss assumed by an economic agent in a financial transaction if its counterparty fails to fulfil its obligations.
As an example, the loss of a counterparty in a loan that is not paid or in a derivatives contract when the other counterparty defaults..
However, like any investment instrument, there are varying levels of risk associated with derivatives.
Among the most common derivatives traded are futures, options, contracts for difference (CFDs), and swaps.
Credit derivatives (CDs) are a type of derivatives instrument that allows the transfer of credit risk from a lender to a third party against payment of a fee.
Credit risk is the risk of loan or debt default.
Defining the eight categories of derivative credit risk:
While a loan has default risk, a derivative has counterparty risk.
Counterparty risk is a type (or sub-class) of credit risk and is the risk of default by the counterparty in many forms of derivative contracts.
Let's contrast counterparty risk to loan default risk.
