Every time an institution extends a loan, it faces credit risk. It is the risk of economic loss when an obligor does not fulfill the terms and conditions of his contracts. Credit risk is seen in all such activities that are impacted by borrowers, issuers, and counterparties, capital-market transactions that have credit exposure. Over the counter derivative transactions that include foreign exchange, swaps and options in particular have both large and dynamic credit exposure. It is important therefore to identify, measure, monitor, and control the credit risks that are inherent while trading in derivative and non-derivative products.
This credit risk management process must be independent and formal. The process needs to be formulated at a policy level and then enumerated through procedures. Looking at historical data and stress testing, one can arrive at methods of measuring credit risk. The limits set should be done based on realistic estimates of the credit-risk exposure. The exposures must then be monitored closely for any sudden changes, which will help the bank prevent against credit risk in an appropriate and timely fashion.
Some of the most common forms of credit risks encountered in trading activities are issuer credit risk and counterparty credit risk. The risk of defaults or credit deterioration of an issuer of instruments that are held as long positions in trading portfolios is known as issuer risk. The issuer credit risk for short time horizon of trading activities is limited in the case of high-quality, liquid instruments. However for more illiquid instruments like loans, emerging market debt and below investment quality debt instruments the issuer credit risk is high.
One of the most significant types of credit risk that banks hedge against is counterparty credit risk. This is the risk that the obligor will default on the terms of contract or the payment contrary to the terms of contract or agreement. There are therefore two types of counterparty credit risk: presettlement risk and settlement risk. By presettlement risk we mean the risk of loss due to counterparty’s failure to perform on a contract or agreement during the life of a transaction. The duration of such transaction is usually a few hours or days, and the presettlement risk is limited to this period. In the event that the exposure may exist for many years at a time, as is the case with derivative products, it is critical banks assess and hedge against such presettlement risk carefully.
Settlement risk on the other hand is the risk of loss when an institution meets its obligation under a contract, through either an advance of funds or securities before the counterparty meets its obligation.
Counterparty default, operational problems, market liquidity constraints, and other factors are some of the reasons for failures to perform at settlement. The window between the time an outgoing payment instruction cannot be recalled until the incoming payment is received with finality is when settlement risk exists. This risk exists with any traded product and is greatest when delivery is made in different time zones.