ISBN 1-56708-091-X

July 1993

Section 2: Working Paper of the Credit Risk Measurement and Management Subcommittee

[Recommendations are numbered as they appear in the Recommendations section of the Global Derivatives Study.]

Credit risk is the risk that a loss will be incurred if a counterparty defaults on a derivatives contract. The loss due to a default is the cost of replacing the contract, less any recovery. The replacement cost represents the present value, at the time of default, of the expected future net cash flows. It is important to emphasize that a credit loss will only occur if the counterparty defaults and the derivatives contract has a positive mark-to-market value to the nondefaulting party. Both conditions have to be satisfied simultaneously for a loss to be incurred.

While the measurement of exposures resulting from derivatives transactions is more complicated than the exposure measurement of many traditional banking products, the principles that govern the assumption and management of credit risk remain the same. Credit exposure management should be procedurally consistent across an organization and, where appropriate, should be fully integrated. Specifically, the evaluation of the credit exposures for derivatives transactions should be made comparable with that of exposures for on-balance-sheet activities. This consistency allows for the integration of derivatives with other on-balance-sheet activities in the credit allocation and review process.

In this Working Paper, the Credit Risk Measurement and Management Subcommittee provides an overview of how credit risk can be measured and monitored. The first half focuses on the measurement of credit risk. It discusses the credit components of exposure on a derivatives contract and presents concepts of current and potential exposure. The following section addresses the calculation of credit exposure on a portfolio of derivatives transactions. Next, the paper discusses the expected credit loss measurements, which are measurements useful for calculating risk-adjusted returns on capital and for allocating capital.

The second half of this Working Paper addresses the management of credit risk. Practices that are helpful in assessing, monitoring, and limiting credit risk are discussed. In this context, the paper analyzes how internal controls, documentation provisions, and credit support arrangements can be used to control credit risk.

I. Credit Risk Measurement

II. Credit Risk Management

III. Conclusion