Financial Education

Derivative contracts are agreements between two parties to pay a cash flow or series of cash flows based on the value of some underlying instrument. Whenever one of the counterparties is owed a cash flow that party faces credit risk: the chance that the other party will fail to honor its obligation. There are a number of ways firms dealing with a large number of derivative contracts can manage this risk.

Position limits are simply pre-set guidelines on how much exposure can be allocated to a given party. The limits could be in dollar terms, a percentage of the notional value of total contracts, or based on other factors (such as allocating a higher limit to more trusted parties.)

Certain futures contracts are periodically “marked to market,” a process by which the interim differences in value are settled before the contracts expire. The associated mark to market payments are smaller and more frequent, reducing the credit risk compared to a single large payment at the end of the contract. The most one party could lose is the change in value during the time since the last mark to market.

Collateral such as margin are required for many contracts. The margin is a small percentage of the notional value kept in escrow. Usually if the margin falls to a specific percentage of how much is actually owed, either more margin must be put up or the margin is paid out and the contract terminated.

Netting procedures are set up for most contracts so that if both parties owe something only the difference (the net payment) is made by the party owing the larger amount. This reduces the credit risk and causes it to apply only to the party owed the larger amount.

Traditional credit analysis techniques can be used to vet counterparties according to credit standards at the outset of a contract. However, if the contract is long-term in nature the credit quality can change during the contract life.

Finally, there are a number of credit derivatives that can be used to transfer specific aspects of credit risk to other parties willing to accept the risk.

An equity swap is an agreement between two parties in which one agrees to pay the total return on an equity or equity index portfolio and the other party agrees to pay an interest payment (usually either a fixed rate or one based on LIBOR) or the return on a different equity or index portfolio.

Swaps can be an efficient way for portfolios to gain access to an index, as the cost of the swap may be lower than the transaction costs of replicating the portfolio.

Active managers may also use swaps as an efficient way of increasing/decreasing exposure to various markets over time.