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 together as one buffer. They protect against different things. IM covers potential future exposure during closeout; VM settles realized P&L. A position with $1M IM and $0.5M VM does NOT have $1.5M of buffer: VM is repaid each day and only IM remains as a true loss-absorber.
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) sits between every buyer and seller through novation, mutualizes default risk, and runs a default waterfall: defaulter's margin, defaulter's contribution, CCP skin-in-the-game, mutualized default fund, assessment rights.
- 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 sequence in order; the defaulter's resources are always first, the CCP's skin-in-the-game always before mutualized losses.
The full lesson (about 3,104 words, 21 min read) adds 2 worked examples, all 6 common mistakes, a self-check, free in the app.
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