Credit Risk and Counterparty Limits: Pre-settlement Risk and Settlement Risk
Credit Risk Limits
Pre-settlement risk (PSR) is the risk that a counterparty to a transaction, such as a forward contract, will not settle or honour his/ her end of the deal.
PSR limits are based on the worst case loss that is likely to occur if the counterparty defaults prior to the settlement of the transaction. The worst case loss assumes an adverse movement in the price/ rate, a client default and the subsequent cost of re-covering the transaction again from the open market. Therefore in setting a limit all three of these factors need to be considered, i.e. the credit worthiness of the counterparty in the same was as is done for traditional credit lines, the likelihood of a adverse market movement and, the cost of covering the transaction from the market.
As the limit is based on the worst case scenario, a VaR based approach has been used in calculating the PSR limits.
For example let us assume that Tom anticipates that the price of crude is likely to increase past USD 83 in the next ten days. To benefit from this position, he enters into a forward contract with Bill to purchase 1000 barrels of WTI Crude Oil 10 days from now for USD 83 per barrel, i.e. for USD 83,000. Currently the price of the crude is USD 81.45 per barrel. If Bill were to default on the deal, Tom would have to cover the position by purchasing 1000 barrels of crude from the market, possibly at a price much higher than the current price. The difference between this higher price and the contract value is the loss that he would suffer on the deal.
Over the past year crude oil price has experienced an average daily volatility of 1.94%. This daily volatility has been calculated using the Simple Moving Average (SMA) approach. The volatility over the pre-settlement period therefore is 6.12% (=1.94%*sqrt(10)). Given this volatility pre-settlement period price impact would be USD 4.98 (=81.45*6.12%), i.e. the price impact is a function of the current price and pre-settlement period volatility. This pre-settlement period price impact may also be denoted as the 1-sigma price impact as the pre-settlement volatility is considered as is and is not enhanced by any factor. This means that given the volatility, the price of crude is expected to move by around USD 4.98 in the next ten days.
However, when determining the PSR Limit we are not merely concerned in determining what the price impact is for a 1-sigma move in prices. What we are really interested in the worst case loss over this period. This worst case loss incorporates a multiple of the volatility into the calculation. The multiple is based on a confidence level or the probability that such an event is likely to occur and is usually taken as 99%. Based on this confidence level the multiple is 2.33 (=the inverse of the standard normal cumulative distribution function at 99% probability) times the volatility or 2.33-sigma.
Recall that VaR, in particular for SMA (or EWMA) VaR, is a function of the SMA (or EWMA) volatility and the inverse of the standard normal cumulative distribution. Hence the PSR limit in this case is based on the 10-day holding VaR at the 99% confidence level.
The worst case price shock is the pre-settlement price impact times the multiple, i.e. 4.98*2.33 = 11.595. This means that during the period before settlement there is a 1% chance that crude oil price will exceed the current price by more than USD 11.595.
The total worst case shock to the current price therefore will be set as the worst case price shock times the number of barrels of crude that would be purchased. This works out to USD 11,595 (=11.595*1000). The market value based on the worst case shock will be USD 93,045 = [(81.45+11.595)*1000].
The PSR loss or the PSR limit that will be set will be the market value of gold based on the worst case shock less the contract value. This works out to USD 10,345 (=93045 – 83000). This is 12% of the contract value at inception (=10345/83000).
Let us consider another example. Sally enters a forward contract with Harry to exchange EUR 100,000 for USD 141,000 after ten days. Sally anticipates that the EUR-USD rate will fall in the near future and she enters the contract to protect her dollar position. If Harry were to default before the contract was to be settled, Sally would have to go to the market to cover her position, in this case to obtain US dollars. If the EUR-USD rate were to decline as she had anticipated she would lose on the transaction as she would get fewer dollars for every EURO. In order to limit her potential losses she calculates the PSR limit applicable to this transaction so that she can take appropriate action if the limit is breached. This she does as follows:
The current EUR-USD rate is 1.395. The rate has experienced an average daily volatility of 0.50% over the last year. This daily volatility has been calculated using the Simple Moving Average (SMA) approach. The other values are calculated as follows:
- Pre-settlement volatility over the ten day period = 0.50% * sqrt (10) = 1.59%
- Pre-settlement FX rate impact works out to =1.59%*1.395 =0.022.
- Worst case FX rate shock (at 99% confidence interval) = 0.022 * 2.33 = 0.051, i.e. the EUR-USD rate falls by USD 0.051.
- Total worst case FX shock (in USD) = 0.05145 * 100000 = 5,145
- Market value based on worst case shock (USD) = (1.345+0.05145)*100000 =144,665
- PSR Loss or Limit (USD) = 144665-141000 = 3,665
- PSR Limit (% of contract value) = 3%
The final PSR limit to be determined would also consider the credit worthiness of the counterparty involved in line with how the credit worthiness is assessed for traditional credit lines. For example if Sally had also entered into a similar contract with Larry and Larry also defaulted on the contract, but Larry’s credit worthiness is worse as compared to Harry’s then Larry’s final PSR limit would ideally be higher than that of Larry’s.
In addition to this limit the credit exposure arising from pre-settlement risk should be aggregated with all other credit exposures for that counterparty and be compared with the overall credit limit for that counterparty to ensure that the credit exposure lies within acceptable bounds.
Settlement Risk Limits
Settlement risk exists only when the principal cash flows have been exchanged but the delivery of the instrument/ asset has not occurred as yet. They are therefore short term in nature however as the risk involves the exchange of the total notional value of the instrument or the principal cash flow, the total dollar value of the settlement risk exposure tends to be larger in most cases than the credit exposure due to pre-settlement risk.
These limits should reflect the credit quality of the counterparty to the transactions, the company’s own capital adequacy, operations efficiency, credit expertise, the efficiency and reliability of the settlement systems and the period of time for which the exposure will be outstanding. The limits would restrict the maximum value of contracts with the same counterparty on the same settlement date.
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