Financial Risk Management: A Practitioner's Guide to Managing Market and Credit Risk by Steven Allen

Author:Steven Allen
Language: eng
Format: epub
ISBN: 9781118231647
Publisher: Wiley
Published: 2012-12-03T16:00:00+00:00

Consequently, we will focus only on products free of credit risk in this chapter, reserving the study of credit risk management for Chapter 13.

Strictly speaking, it is only bonds issued by the central government (for example, U.S. Treasury bills and bonds in the United States) that are (nearly) completely free of credit risks. It is only the central government that has unlimited power to issue its own currency and so can (nearly) certainly meet any obligations to pay that currency. But fixed-income trading desks of investment banks generally also trade a variety of instruments whose credit risk is extremely low: bonds issued by agencies of the central government, mortgages guaranteed by such agencies, and derivatives tied to bank indexes such as the London Interbank Offered Rate (LIBOR). This latter case is a particularly important class for interest rate products; indeed, the largest interest rate risk exposures of financial institutions is usually to LIBOR products: LIBOR futures, forward rate agreements, swaps, caps, floors, and swaptions. So we ought to examine closely why credit risk on these products is considered negligible and why it predominates over Treasury rates as the basis for derivative products.

First, we need to distinguish between the credit risk to the counterparty on a derivative and the credit risk on the derivative instrument itself. Consider the example of a typical derivative tied to LIBOR, a 10-year interest rate swap of fixed coupon payments against three-month US Dollar LIBOR reset each quarter. Certainly there is credit risk that the counterparty will default on its obligations under this contract, with the severity of risk tied to the creditworthiness of the counterparty. But this has nothing to do with credit risk of the swap itself. An equity option or foreign exchange swap or option on a Treasury bond would also entail counterparty credit risk but no underlying credit risk. By contrast, a default swap in which you must pay Company A an agreed amount based on the default of Company B against fixed payments to you from company A entails both counterparty credit risk of losing your fixed payments if company A defaults and underlying credit risk of Company B defaulting.

So we need to see whether there is any underlying credit risk on a bank index product. Let us continue with our example of the 10-year swap based on three-month US Dollar LIBOR resets. There is clearly some credit risk—a severe economic downturn will raise concern about potential bank defaults and therefore raise the rate that banks need to pay on three-month deposits relative to three-month Treasury bill rates. But to see just how small this element of credit risk is, let us contrast it with the credit risk on a 10-year bond issued by one of the banks whose deposit rates form the LIBOR index, noting that the credit risk on this bond is very small to begin with, since all banks in the index are of very high credit quality, generally Aa. The credit spread on the 10-year bond needs

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