End-users should also periodically review their own credit exposures to counterparties. The frequency depends on the size of the portfolio, the number of counterparties, and the extent to which credit exposures can be material.

In addition to monitoring the current and potential exposures of derivatives transactions, it is extremely important to monitor the creditworthiness of the counterparty and its compliance with any documentary financial standards. This practice enables dealers and end-users to take full advantage of any risk management tools available to them.

Credit risk exposure should be managed in relation to specified credit limits. Most institutions have a credit department that reviews the creditworthiness of its counterparties on an ongoing basis and increases or decreases the credit limits for these counterparties as appropriate. Systems should be in place to identify exposures to counterparties that are approaching or exceeding their credit limits. When these warning signals are triggered, policies aimed at bringing existing exposures within their credit limits and preventing exposures from increasing further should be implemented. For instance, such policies would include the following: no new transactions with that counterparty should be executed that increase exposures; active efforts should be made to assign or reverse existing transactions or to execute new transactions that reduce total credit exposure; and negotiations relating to collateral or other credit enhancements should be initiated.

Credit losses can occur. Accordingly, it is important that derivatives dealers appropriately reflect their credit exposures when measuring the results of their derivatives activity. Credit risk of derivatives transactions should be treated in the same manner as credit risk of on-balance-sheet transactions. There are two components of credit risk which should be recognized: the unearned credit spread for general credit allowance which will be earned over time as compensation for being exposed to credit risk; and an amount, if appropriate, to cover probable credit losses. The magnitude of these adjustments should be based on a prudent estimate of the credit losses the portfolio could experience, and can be related to the overall credit reserve of the dealer.

Factors that should influence the credit allowance include the creditworthiness of the counterparties, the magnitude of the potential exposure on the underlying transactions, netting arrangements, collateral arrangements, and the maturity of the underlying transactions. As stressed in this Working Paper, credit risk is a dynamic concept that changes with the passage of time and movements in the underlying variables. The credit adjustment to the value of derivatives portfolios should be based on procedures that reflect this dynamic nature and that provide for an increase or reduction in credit adjustments as the credit risk parameters in the portfolio change.

The Survey asked dealers how they calculate unearned credit spread. Almost half say they currently use a transaction-by-transaction approach. In contrast, only 18% follow a counterparty-by-counterparty approach at the present time, but 33% intend to do so in the future. Provisions for unearned credit spreads typically are taken into earnings over time. The most common approach is on a straight-line basis over the life of the transaction(s). Only 16% reported that the credit spread earned over time is made as a function of the counterparty exposure.

The Survey indicated that dealers are adopting a conservative approach with respect to providing for probable credit losses. Approximately two-thirds of the dealers surveyed currently allow for probable credit losses in addition to unearned credit spread. Specifically, 39% of the dealers surveyed have a general allowance (reserve) and about 25% have an allowance (reserve) for specific probable losses. In the future, approximately 80% of those surveyed intend to have reserves with about half of them opting for general reserves and about half planning for reserves against probable losses.