holders in terms of higher default recoveries. We shall revisit thesetopics later on.We have discussed the symmetry between the credit charge andcredit benefit, i.e., one’s credit charge on a counterparty portfolio isone’s counterparty’s credit benefit on the same portfolio, and vice versa.There is also a symmetry between the credit cost and credit benefit. Ifone uses exactly offsetting portfolio to hedge the original portfolio, thenthe credit cost on the original portfolio is the credit benefit on the hedgeportfolio (assuming that the collaterals are rehypothecatible), and viceversa.To put it in another way, the credit cost in the OTC derivatives business for an entity below LIBOR credit quality comes from the fact that itneeds to borrow at LIBOR plus a positive funding or credit spread to finance or fund the receivables from OTC derivatives. So one’s credit costis the interest expense that one needs to pay on one’s funding or creditspread and the expected amount that needs to be funded throughout thelife of the OTC derivatives, which really is the cost of one’s credit quality.Another way to understand the credit cost is to compare it withrep^.'^ If one’s receivables are from assets that can be repoed, then onecan finance or fund the receivables at the corresponding repo rate (whichcan be lower than LIBOR). In this case, the receivables are also dis19
For more discussions on repo, the reader can refer to, Section 2.2.2, Fleming and Garbade (2003), and Duffe (1996).
16
Introduction to Counterparty Credit Risk
Chapter 1
counted or PVed at the corresponding rep0 rate and thus one does notsuffer from the credit costs based on one’s credit quality or credit spread.OTC derivatives typically cannot be repoed and thus would incur thecredit cost. This credit cost can be possibly arbitraged away with variousstrategies, including a synthetic repo strategy (which shall be discussedlater).The cash accrued funding benefit on a portfolio is the benefit broughtin by the realized incoming cashflows in the portfolio and the futureshedges (which reduces the borrowing at the desk level or the firm level).In other words, the cash accrued funding benefit is the interest earned bythe realized incoming cashflows based on one’s funding spread. Thecash accrued funding benefit is included in the credit benefit, which alsoincludes the benefit of the expected future incoming cashflows. Thus,care must be taken in order to avoid double counting.The cash accrued funding cost on a portfolio is the cost generated bythe realized outgoing cashflows in the portfolio and the futures hedges.In other words, the cash accrued funding cost is the interest paid by theoutgoing cashflows based on one’s funding spread. The cash accruedfunding cost is included in the credit cost, which also includes the cost ofthe expected future outgoing cashflows.The collateral accrued funding benefit on a portfolio is the benefitbrought in by the currently received (or realized) collaterals that can beused as collaterals posted in a secured loan to obtain a lower f h d i n grate. If the collaterals are posted to a custodian account, then the treatment is different.The collateral accrued funding cost on a portfolio is the cost generated by the currently posted (or realized) collaterals that needs to befunded at LIBOR plus one’s funding or credit spread.The accrued funding benefit and the accrued funding cost are Treasury and accounting functions based on one’s current (or realized) cashbalance and collateral balance, whereas the credit charge, credit benefit,and credit cost involve both realized and unrealized (or expected) futuresvalues and thus require sophisticated modeling. A dealer also needs tobe careful to achieve proper allocation or distribution of these benefitsand costs within the firm.For entities with better than LIBOR credit quality, their credit costsand credit benefits switch signs, i.e., the credit benefits become costs and
Sec. 1.3
Trading Strategies and Opportunities
17
the credit costs become benefits.20
1.3
Trading Strategies and Opportunities
Here we discuss some examples of trading and arbitraging strategies involving counterparty credit risk, such as hedging of one’s credit charge,monetizing one’s credit benefit, reduction of one’s credit cost, andachieving trade cheapening for one’s counterparty.Like any other trading strategies, these trading strategies involvetrading or balancing between the PV and future state payoffs or risks. Inother words, more (or more likelihood of) future receivables and/or less(or less likelihood of) future payables in a trade means a higher value inthe PV of the trade, and vice versa.To facilitate our discussion, we thus partition the joint market andcredit states of two trading parties of A and B as follows. The marketstates (M) can be partitioned based on the sign of the MTM of the portfolio to one of the parties, say Party A, which can be positive (+) or in themoney or negative (-) or out of the money to Party A. The credit states(C) can be partitioned into 4 states, i.e., none of the parties defaults (ND),A defaults first (AD), B defaults first (BD), and both parties default (D)at the same time (or within the same time interval). See Table 1.1.Furthermore, we use VA(M,C) to denote the MTM value of the portfolio to Party A at a joint market and credit state (M,C), and RA and RB todenote the default recovery rates for Party A and B, which can also bestate dependent. Here we assume the recovery as a fraction of the MTMvalue or the replacement value VA(M,ND)of the corresponding nondefaultable or LIBOR quality trade. Other recoveries assumptions canbe handled in a similar manner.
2o It can happen that an entity’s short term debt has a credit quality above LIBOR, but its
long term debt is below LIBOR quality.
18
Introduction to Counterparty Credit Risk
Chapter 1
Table 1.1. The joint market and credit states for two trading parties of A and B.The MTM for the trade (or the netable portfolio) or the market states can bepositive (+) or negative (-) to Party A. The credit states include none of theparties default (ND), A defaults first (AD), B defaults first (BD), and both partiesdefault (D).
Market States (M) or MTM to A
+
Credit States (C)ND A D ~ B DDND A D ~ B DD
The prevailing asymmetric default treatment has asymmetric lossgiven default (LGD) or, more generally, loss given event (LGE) as illustrated in the following Table 1.2 and Figure 1.2.Table 1.2. LGE from the point view of part A under the prevailing asymmetricdefault treatment. The asymmetry comes from the fact that Party A has defaultgain in state (-,AD), but no default loss in state (+,AD). Similarly, Party A hasdefault loss in state (+,BD), but no default gain in state (-,BD).
Sec. 1.3
19
Trading Strategies and Opportunities
(a>
VA(+, ND)W+,WVA(+,BD) AVA(+,D)Party B
I
VA(-,ND) VA(-,BD)
Figure 1.2. The MTM to Party A at various states.
The asymmetry comes from the fact that Party A has default gain instate (-,AD), but no default loss in state (+,AD), or equivalently, Party Bhas no default gain in state (+,AD). Similarly, Party A has default loss instate (+,BD), but no default gain in state (-,BD), or equivalently, Party Bhas no default loss in state (+,BD). In other words, the asymmetry canbe expressed as
The symmetric LGE used in some of the trading strategies formonetizing the credit benefit or reducing the credit cost are shown inTable 1.3.
20
Introduction to Counterparty Credit Risk
Chapter 1
Table 1.3. Symmetric LGE from the point view of part A. Party A has defaultgain in state (-,AD) and default loss in state (+,AD). Similarly, A has default lossin state (+,BD) and default gain in state (-,BD).
+-
NDADBDD0 (1-R,)V,(+,ND)(1-RB)V,(+,ND) (I -RA)(1 -R,)VA(+,ND)0 (l-RA)VA(-,ND) (~-RB)VA(-,ND) (1 -RA)(1-RB)VA(-,ND)
The symmetry can be achieved by credit contingent derivatives oradding credit contingent terms on the existing trades. The easiest way ofstructuring a symmetric LGE trade is to structure a credit contingentknock-out trade (which is also termed as credit extinguisher), i.e., a tradethat is knocked out (typically with zero-recovery or rebate) if either partydefaults regardless who is in the money. These are also termed as zerorecovery swaps or derivatives or credit extinguishers. These trades arenot legal in all jurisdictions.With the above strategy, one can structure a trade whereby one paysa premium to one’s counterparty due to the counterparty’s likelihood ofdefault. An example of such trade is that one longs a zero-recovery receiver interest rate swap (i.e., a receiving-fixed-and-paying-floatingswap) in an upward sloping yield curve environment, as, in this case, onecan have more counterparty default gain than counterparty default loss.Another example is a zero-recovery cross-currency swap where one receives a weaker currency and pays a stronger currency.This is also one way for one to sell default protection on oneself(which is not legal in all jurisdictions). The reader may want to thinkmore carefully about the rationales in our conclusion and where does thevalue come from.In general, a credit contingent derivatives instrument has a payoffcontingent on a credit event happening and a payoff contingent on acredit event not happening. Such payoffs are further linked to an underlying trade (or asset) or a basket of underlying trades (or assets).The credit event typically is a default event, but can be other eventssuch as credit rating downgrade or change. In an equity default swap(EDS), the contingent event is the equity price being below a certainlevel, typical a level much lower than the spot equity price. Essentially,an equity default swap is a series of deeply out-of-the-money equity putoptions.
Sec. 1.3
Trading Strategies and Opportunities
21
Broadly speaking, credit derivatives and defaultable derivatives arenaturally credit contingent derivatives. However, the defaultable derivatives are often more complicated and are often hybrid derivatives between credit derivatives and the underlying trades and assets, which, inturn, can be highly complicated or compound derivatives.Examples of credit contingent instruments include CCDS and creditextinguishers. A CCDS is a contingent CDS whose notional is contingent on or linked to the PV of an OTC derivatives instrument. It provides default protection (to the protection buyer) on the OTC derivativesinstrument by providing the replacement of the same instrument upon thedefault of the reference credit. In other words, it is an OTC derivativesinstrument with a knock-in feature upon the default of the referencecredit.A credit extinguisher, on the other hand, is an OTC derivatives instrument with a knock-out feature upon the default of the reference creditwith a pre-specified rebate (that can be zero or non-zero). The rebate canalso be linked to the face value of the defaulted bonds of the referencecredit, which is similar to the ISDA” set-off provision whereby, underproper circumstances, one is allowed to offset one’s payables to a counterparty by delivering defaulted bonds of the counterparty with the facevalue equal to the PV of the payables.The typical motivation of a CCDS is to trade the credit risk in anOTC derivatives instrument and provide a static hedge of the counterparty credit risk (as apposed to a dynamic.hedge with CDS). The typicalmotivation of a credit extinguisher is to achieve trade or funding cheapening for the counterparty. It is important to point out that the credit extinguishers are not legal in all jurisdictions.Some brokers are working on sourcing liquidity for the market forsome of these instruments. For more information, the reader may wantto refer to, e.g., http://www.SwapMeCredit.com.Below we present a few examples on credit charge, credit benefit,credit cost, and various strategies to help the reader build intuitions.Let’s first take a look at a simple example one-side exposureswhereby one of the parties has only credit benefit and the other party hasonly credit charge and how the credit benefit can be naturally monetized.Example 1.1. One-sided exposures. Suppose a dealer, Party A (withISDA stands for International Swaps Dealers Association.www.isda.com for more details.
The reader can refer
22
Introduction to Counterparry Credit Risk
Chapter 1
lower than LIBOR credit quality), sells an option to Party B with the fullupfront premium. In this case, both parties have one sided exposures, ormore specifically, Party A (with only payables and no receivables) hasno credit charge and only has credit benefit, and Party B (with only receivables and no payables) has only credit charge and no credit benefit.Theoretically, the credit benefit of Party A (which, by symmetry, is alsothe credit charge on Party A from the point of view of Party B) should bepassed to Party B to compensate the credit risk that Party B undertakes.Otherwise, Party B would rather trade with a counterparty of highercredit quality.Let’s further assume that the PV of this trade to Party A is -$20MMbased on LIBOR discounting (broker’s quote) and the credit benefit forParty A is $1MM and the credit charge for Party A is zero, and, by symmetry, the credit charge from the perspective of Party B is -$lMM andthe credit benefit from the perspective of Party B is zero.22Thus, theoretically, Party A can only charge Party B $19MM(= - ( - $20MM + $lMM)) for this trade. In other wards, Party A paysParty B $lMM relative to the LIBOR-discounted PV of $20MM. Doesthis mean that Party A has lost $1MM and Party B has made a profit of$1MM upon the execution of this trade?The answer, of course, is no. This $1MM is the MTM value of thecounterparty risk or the embedded default option. In other words, PartyA should mark the trade at -$l9MM (with the absolute value of its payables or liability marked down by $1MM) and Party B should mark thetrade at $19MM (with its receivables or asset marked down by $1MM).Therefore, both parties have zero P&L upon the execution of this trade.More specifically, the $1MM that Party B receives is its creditcharge on Party A to cover the cost of buying default protection on PartyA (such that Party B will only have LIBOR credit risk). Even if Party Bdoes not buy credit protection, the trade should still be marked down by$1MM, as this $lMM is from taking the credit risk of Party A andshould be amortized through out the life of the trade. By marking thetrade with its credit charges and remarking it, Party B achieves such amortization.Similarly, $1MM that Party A pays is its credit benefit that can bemonetized or earned back from the cash funding benefit from the22 Since one has a short position in the option due to the counterparty’s default, one’s
credit charge is zero or negative. Similarly, one has a long position in the option due toone’s own default, thus one’s credit benefit is zero or positive.
Sec. 1.3
Trading Strategies and Opportunities
23
$19MM cash received from Party B (which, in turn, can be used to retireparty’s A bonds), and plus, on average, the net cashflows from the hedging futures contracts if this trade is Delta hedged using futures, and ifnone of the parties default during the life of the trade.In this case, the credit benefit is not hedged or locked in, as Party Acan earn back more or less than $1MM depending on the future realizedmarket scenarios (or the path that the market follows in the future). Inother words, if the market follows a future path whereby this trade ismore out of the money for Party A (or its liability increases), then thehedging futures will make money and bring in more cashflows, and thusParty A will earn back more than $1MM. On the other hand, if the market follows a future path whereby this trade is more in the money forParty A (or its liability decreases), then the hedging futures will losemoney and result in outgoing cashflows, and thus Party A will earn backless than $1MM.The next example discusses the hedging strategy using offsettingtrades.
Example 1.2. Offsetting trades. Assume that we have the same situation as the previous example, except that Party A (a dealer) hedges itstrade with Party B by entering an exact offsetting trade with Party C (i.e.,by buying the same option). For simplicity, let’s further assume thatParty C is of LlBOR credit quality.In this case, Party A does not need to collect a credit charge fromParty C for the offsetting trade, as Party C is of LIBOR credit quality.Also, Party A does not have credit benefit from the offsetting trade, asthe trade always has positive exposures (or receivables) to Party A. Orequivalently, Party C does not need to collect a credit charge from PartyA. In other words, Party A needs to pay Party C $20MM for the offsetting trade.As a result, Party A has a pair of offsetting trades, but yet seems tolose $1MM.To view this situation from a different angle, we can see that Party Ahas effectively conducted a lending business by borrowing funds at itsown credit quality (from Party B) and lending the funds to another entity(Party C) with better credit quality. We know that an entity with lowercredit quality is in a disadvantaged position to conduct lending business,especially to entities with better credit quality.
24
Introduction to Counterpar@ Credit Risk
Chapter 1
If none of the parties default during the life of these trades, thenParty A will indeed lose the $1MM. The question is where does this$1MM go? Since Party B and Party C do not profit from this $1MM(before Party A defaults), who profits from this $1MM?The answer lies in what happens when Party A does default, inwhich case, Party A receives the full market value from its trade withParty C, but only needs to pay a fraction (or the default recovery) of themarket value for its trade with Party B due to the asymmetric treatmentof default.Thus, Party A actually has a net realized default gain. Such defaultgain essentially can result in an enhanced default recovery to all its creditors, including the bondholders, at the cost of Party A (of $ 1MM).Theoretically, this enhanced recovery should result in a tighter creditspread for Party A. However, from a practical standpoint, this information would not be transparent enough for the market to price in, particularly since the trading parties have the option to terminate or unwind thetrades at the prevailing MTM values (which can eliminate the enhanceddefault recovery).Nonetheless, Party A has the full knowledge of this valuable information and can apply arbitrage trading strategies to monetize back this$1MM (which is essentially for Party A to monetize its credit benefit orto reduce its credit cost). By Party A executing these strategies, part ofthe information is revealed in the market place, which is helpful to themarket information discovery and production process, which, in turn,helps the market become more transparent and efficient.One conceptual trading strategy is that Party A can grant a creditcontingent option to its trade with Party C such that when Party A defaults, Party C only needs to pay a fraction of the MTM value of thetrade, if the trade is in the money to Party C. This fraction shouldroughly be the same as the default recovery rate of the original trade between Party A and Party B. This essentially makes the default treatmentof Party A symmetric. The reader may realize that this is the same asmaking the trade between Party A and Party C a credit extinguisher (thatextinguishes upon the default of Party A).Thus, theoretically, Party C should pay Party A roughly $1MM (oran annuity of $1MM PV) for this contingency. Clearly, Party C willbenefit from Party A’s default, and, as such, Party C can sell default protections on Party A to monetize this benefit to make up the $1MM it paysto Party A. Party C can do so by selling protections using CDS (if it is a
Sec. 1.3
Trading Strategies and Opportunities
25
dealer) or by selling the credit contingency to a dealerz3 (who, in turn,can use CDS to dynamically hedge it). Unlike the previous examplewhereby the amount of the monetized cashflows has a volatility and itworks on the expected value sense, the arbitrage strategy by selling thecredit contingency locks in the amount of the monetized cashflows withno volatility.The credit contingency that Party A enters into with Party C essentially is a synthetic rep0 for Party A to fund its trade with Party C.The credit contingency that Party A enters into with Party C is actually one way for Party A to sell credit protection on itself fully collateralized by its trade with Party C. It is interesting to point out that Party Amay not be able to sell such protection to any other parties, as its tradewith Party C may not be accepted as collateral by other parties.With this credit contingency, Party A will have incentives to unwindits trade with Party C prior to default. In this case, the credit contingencyunwinds too, and Party C needs to charge Party A the then MTM valueof the credit contingency. Party C may also need to unwind its hedgesfor this credit contingency. Theoretically, all these activities increase thedemand on the credit protection on Party A and thus can create a pressure for the credit spread of Party A to widen, which, in turn, producesmore information on the implied views on Party A’s credit quality.
Example 1.3. Assume that we have the same situation as in Example 1.1or Example 1.2. With the strategies discussed, Party A is flat on itscredit benefit and credit cost (and its credit charge). However, Party Bstill suffers a loss on its credit cost if it hedges its trade with Party A byusing futures, or a loss on its credit benefit if it hedges its trade withParty A with an exact offsetting trade with Party D of LIBOR quality.Similar to the previous example, conceptually Party B can arbitrageback its credit cost or credit benefit by granting a credit contingent optionon the trade to Party A such that when Party B defaults, Party A onlyneeds to pay a fraction of the MTM value of the trade. This is the sameas making the trade between Party A and Party B a credit extinguisher(that extinguishes upon the default of Party B).Example 1.4. Assume that we have the same situation as in Example1.3, except that Party A enters into a collateral agreement or an ISDA23 Selling protections using CDS is a dynamic trading strategy and selling the credit contingency is a static strategy.
26
Introduction to Counterparty Credit Risk
Chapter 1
Credit Support Annex (CSA) with Party B such that Party A postsenough collateral on the trade to cover the default loss. Thus, Party Bneeds to charge Party A no (or minimal) credit charge. In this case, PartyB still needs to arbitrage back its credit cost. However, the credit contingent strategy used previously has almost zero value in this case.If the collateral that Party B receives from Party A can be posted outor rehypothecated to obtain close to LIBOR (or better than LIBOR)funding, then obtaining such funding is the strategy to arbitrage back thecredit cost for Party B.Here are some concluding remarks for the above examples.The trade between Party A and Party B brings in credit benefit toParty A. The credit benefit is passed to Party B, as it is the same as thecredit charge that Party B needs to charge Party A. One question thatimmediately arises is whether or not Party A losses money because ofthis.If Party A hedges its trade with Party B by entering an exact offsetting trade with Party C (of LIBOR credit quality), then there is a puzzlethat Party A has two completely offsetting trades and yet has a net$1MM outgoing cashflow (coming from the extra credit cost from thetrade with Party C). This puzzle is solved by the credit contingent (orcredit extinguishing) option that Party A grants to Party C, which earnsback roughly $1MM for Party A. This credit contingency or credit extinguisher is a synthetic rep0 agreement and is also one way for Party Ato sell protection on itself to achieve the fair default recovery priced inthe market. This credit contingency or credit extinguisher also makes thedefault treatment of Party A symmetric.The above discussions are based a portfolio with one-sided exposures. For trades or a portfolio with two-sided exposures, such as swaps,exposures are equivalent to long positions of a series of call options onthe portfolio and short positions of a series of put options on the portfolio. Then, the above discussion can be applied to each of the options.In general, selling the credit contingent option to one’s counterpartyis a key to monetize one’s credit benefit and reduce one’s credit cost.Similarly, buying the credit contingent option from one’s counterparty isa key to help one’s counterparty monetize its credit benefit and reduce itscredit cost and is also one way to achieve cheapening of the trade price toone’s counterparty.
See. 1.3
Trading Strategies and Opportunities
27
The credit contingent trades referencing one’s own default (or selfreferencing) that we discussed above may not be easy to execute. In addition to credit extinguishers, another way of executing these trades is topost one’s OTC derivatives receivables as collaterals.The above examples and strategies deal with how to monetize thecredit benefit and credit cost. Another application of the credit contingency strategy, such as using CCDS trades, is to provide static hedgingfor the counterparty credit risk or to hedge or lock in the credit charge,which is much simpler conceptually.Another general way of reducing the counterparty credit risk is torevert back to funded trading or securitization of OTC derivatives byembedding a OTC derivatives instrument in a structured note. Examplesof this strategy include various structured interest rate or equity notes(with exotic interest rate or equity derivatives embedded), CLN (creditliked notes) as opposed to CDS, funded CDO/CS024placement. Othergeneral ways of reducing the counterparty credit risk (and improvingliquidity) is through the creation of ETF (exchange traded funds) andfutures with daily marking to the market.Another interesting area is to use equity and equity derivatives (including EDS or Equity Default Swaps) to hedge credit risks.Based on what has been discussed in this section, in addition to itshedging functionality, the credit charge hedging and trading can also potentially become a profit center through, e.g., monetizing values in creditcost, credit benefit, and credit charge, achieving trade (or funding)cheapening for the counterparty, and facilitating others to staticallyhedge the counterparty credit risk. These are essentially credit hybridtrading opportunities.One intriguing way of managing the counterparty credit risk in OTCderivatives is through (tranched) securitization. In other words, the receivables from the OTC derivatives can be used as the underlying assetsof a CDeO (Collateralized Derivatives Obligations) structure in a similarway as the receivables from bonds or CDS as the underlying assets of aCDO or CSO.A specific example is the UBS Alpine structure whereby the receivables from the OTC derivatives in UBS’ trading book were structuredinto different riskheward tranches that were sold to investors.25 AdvanCDO stands for Collateralized Debt Obligations and CSO stands for CollateralizedSwap Obligations.25 See, e.g., http://db.riskwaters.com/public/showPage.html?page=ll686for more details.
24
28
Introduction to Counterparty Credit Risk
Chapter 1
tages of this securitization are the saving of the hedging cost of the counterparty credit risk as compared to using single-name CDS, saving of thecredit cost, and the ability of reducing the balance sheet usage and freeing up credit limits so that more derivatives transactions can be conducted.Other interesting strategies include OTC IR swaps clearing servicesprovided by SwapClear26 from London Clearing House (LCH).O T c D e r i ~ N e t ,a~ consortium~formed by world’s leading investmentbanks, is trying to expand the efforts by Swapclear.
1.4
Comparison with Bond Credit Risk
Credit charge is of the same origin as bond credit spread. The bondholders implicitly grant the bond issuer an option to default. In other words,the bond holder has sold a default protection on the bond. The payoff ofsuch default option or protection at default is the payoff of a put optionon the bond (struck at the par). In other words, the bondholders are shorton a credit contingent (or a knock-in) put option on the bond to the bondissuer. The stock price, on the other hand, is the PV of a down-and-outcall option on the shareholder’s equity.A hypothetical LIBOR credit quality entity can issue floating bondsat LIBOR flat, i.e., with par coupon being the same as LIBOR. But anentity with lower credit quality than LIBOR can only issue bonds atLIBOR plus positive spreads2*so as to compensate the bondholders forthe credit risk29that they undertake. These spreads are the bond fbndingcosts for this entity.The credit charge and the bond credit spread differ in several important ways. To illustrate the impact of such differences, it is interesting toask the following question. If an entity can fund at, say, LIBOR +100 bps by issuing a 10-year floating bond at par, what is an estimate ofthe net credit charge for it to enter a 10-year par swap?It turns out that the net credit charge, in terms of a swap funding orcredit spread, can have a range of values. Particularly, the sign of net26 See http://www.lch.com/services/swapclear/.
” See http://www.otcderivnet.com/.
*’
Such spreads typically exhibit a term structure and it can happen that an entity’s shortterm debt can have a credit quality above LIBOR, but its long term debt can be belowLIBOR quality.29 More precisely, the additional credit risk not priced in by the LIBOR credit quality.
Sec. 1.4
Comparison with Bond Credit Risk
29
credit charge or premium can be either negative (corresponding to a cost)or positive (corresponding to a gain). Also, the magnitude of the swapfunding spread can be a small percentage of the bond funding spread, ora few basis points in this case. These can be explained by the foIlowingdifferences between a bond and a swap.The exposure and the credit risk in the case of a bond are one-sided,i.e., the bondholders are owed money by the bond issuer (or the bondholders have net receivables from the bond issuer) and thus are exposedto the bond issuer, but not vice versa. In the case of a swap, since twoparties in the swap exchange cashflows, the exposure and the credit riskare two-sided, i.e., each party of the swap can suffer from credit loss ifthe other party defaults, which means the swap funding spread or the netcredit charge is determined by the differential of the expected loss of thetwo counterparties. In addition, in the case of a bond, all the couponsand the entire principal are at risk, whereas in the case of a swap, onlynet cashflows are at risk, that means the exposures, in the case of theswap, are much smaller.30
Question 1.3. What about the cases in which derivatives exposure isone-sided?
Even though the net credit charge in terms of the credit spread forswaps, and for derivatives in general, is much smaller than the creditspread of bonds, the impact of the net credit charge can be very significant as it can exceed the bidask spread of the derivatives in some cases(especially with lower credit quality counterpart