Credit Risk in Selected Derivative Instruments: Understanding credit risk and the various methods of determining the credit risk in Foreign Exchange Forward Contracts and Interest Rate Swaps

Derivative instruments are used daily by banks to provide hedging to clients and to generate profits from trading. To facilitate the use of derivatives, credit facilities are allocated to clients and counterparties. The methods to determine the credit risk associated with these instruments have gone through a number of evolutionary phases. The first phase involved the use of the notional amount of the outstanding derivative instrument. The second phase involved a percentage of the outstanding notional amount of the derivative instrument. The third phase involved the marked-to-market value of the instrument and was further expanded to include a value for the potential future exposure during the remaining life of the outstanding instrument. The fourth phase and current phase involves the aggregation of a counterparty's risk across different instrument types taking into consideration correlation of price factors to arrive at a net exposure. This study was undertaken to discuss these phases as they are applicable to two derivative instruments. These intruments are interest rate swaps and forward foreign exchange contracts.