Two banks enter a $500 million ten-year interest rate swap. A decade later, one bank has gained $40 million on the trade and the counterparty has lost $40 million. If the loser fails before settling, the winner's $40 million unrealized gain becomes a defaulted receivable. That counterparty credit exposure is what derivatives risk management exists to control.
A derivative is a contract whose value depends on an underlying asset, rate, or index. The four basic building blocks are forwards, futures, swaps, and options. Everything else (exotic options, structured notes, credit default swaps) is a combination of these.
- Forward: agreement to buy or sell an asset at a fixed price on a future date. Over-the-counter (OTC), customizable, no daily settlement.
- Futures: exchange-traded forward with standardized terms, daily mark-to-market, and central clearing.
- Swap: exchange of cash flow streams (fixed-for-floating interest, one currency for another, fixed-for-floating equity return).
- Option: right but not obligation to buy (call) or sell (put) at a strike price. Buyer pays premium upfront; seller takes premium and assumes obligation.
Common mistakes
- Confusing current exposure with potential future exposure. Current exposure is mark-to-market today (zero or positive); potential future exposure is the maximum credit exposure over the life at a chosen confidence. A trade with zero current exposure can have substantial PFE.
- Treating netting as automatic. Netting requires an executed Master Agreement with an enforceable netting provision in the relevant jurisdiction. Without it, the bank's gross positive marks are receivables and the bank's negatives are liabilities: no offset. Trap: "the bank has $11M in positives and 6M" without confirming netting enforceability is wrong.
- Adding initial margin and variation margin as if both cover the next price move. Initial margin covers potential future exposure during closeout. In a settled-to-market contract, variation margin transfers the daily mark-to-market gain or loss; it is not automatically repaid each day.
Bottom line
- Derivatives derive value from an underlying asset; linear payoffs (forwards, futures, swaps) move proportionally with the underlying, while non-linear payoffs (options) have asymmetric profit profiles.
- Exchange-traded contracts are standardized and centrally cleared; OTC contracts are bespoke and bilaterally negotiated, with higher counterparty credit risk.
- A central counterparty (CCP) replaces bilateral trades through novation. A common waterfall uses the defaulter's margin and default fund contribution, dedicated CCP capital, then surviving members' fund, with further assessments governed by the rulebook.
- Initial margin sizes potential future exposure; variation margin settles daily P&L moves; they are independent buffers that both reduce counterparty credit risk.
Exam shortcut
When a question asks about credit exposure, identify whether it is asking for current exposure (today's mark-to-market) or potential future exposure (worst-case over the life). Read scenarios for the words "today" vs. "over the life": they decide which number is wanted. For waterfall problems, work through the rulebook's layers and track the loss remaining after each. For a waterfall, identify whose resources absorb each loss and when mutualization starts.
The full lesson (about 5,589 words, 37 min read) adds 2 worked examples, all 6 common mistakes, a self-check, free in the app.
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