The methods of determining the presettlement risk for different instruments vary. The presettlement credit exposure for cash instruments is measured as the current carrying value, which for trading operations is the market value or fair value of the instrument. The market values can be obtained from direct market quotations and pricing services.
In the case of more complex instruments, presettlement risk can be valued using generally accepted valuation techniques. The credit exposure for derivative contracts, is measured as the sum of the current value or replacement cost of the position, and an estimate of the institution’s potential future exposure to changes in that replacement value in response to market price changes. Together, replacement cost and estimated potential future exposure make up the loan-equivalent value of a derivative contract.
Presettlement exposure to a counterparty exists whenever a contract’s replacement cost has positive value to the institution for derivative contracts and is known as “in the money”. The exposure has a negative value to the counterparty and is known as ‘out of the money’’. The current replacement cost of the contract is its mark-to-market value.
The other counterparty has an immediate exposure which must be filled if the counterparty defaults on a transaction before settlement of the deal. The non-defaulting counterparty suffers a credit loss if the contract is in the money for the non-defaulting party. Any and all deals with a positive mark-to-market value represent actual credit exposure. The replacement cost of derivative contracts is usually much smaller than the face or notional value of derivative transactions.
Swaps and other derivatives involving firm commitments initially have a zero net present value and, therefore, no replacement cost at inception. The only potential for credit exposure these contracts can have at inception can arise from subsequent changes in the market price of the instrument, index, or interest rate underlying them. Positive contract values occur when market prices move which results in the contract developing its current credit-risk exposure of its replacement cost as well as the potential credit exposure that can arise from subsequent changes in market prices.
Swaptions and rate protection agreements which are options and derivative contracts which contain options face both current and potential credit exposure. The difference, however, with option contracts is that they have a positive value at inception reflected by the premium paid by the purchaser to the writer of the option. While the value of the purchased option may be reduced as a result of market movements, it cannot become negative. The seller or writer of an option receives a premium, usually at inception, and must deliver the underlying at exercise. Therefore, the party that buys the option contract will always have credit exposure when the option is in the money. The party selling the option contract will have no credit exposure other than settlement risk while awaiting payment of the premium.