T6.docx - Week 6 These questions cover Chapters 5 and 6 of...

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Week 6: These questions cover Chapters 5 and 6 of the textbook Dynamic credit exposure: the credit exposure is not always fixed but can be dynamic when it depends on the market value of an underlying asset. Dynamic credit exposures can stem from various families of transactions: Derivatives transactions Long-term sale or supply contracts Repo (repurchase) transactions What creates the dynamic credit exposure is the difference between the predetermined conditions and the prevailing ones at the time of the expected payment of sale/purchase. The risk taken by an entity entering into a derivative transaction is that its counterparty fails to make the payments due under the terms of the contract. The credit exposure is the replacement cost, which is the economic value of the derivative transaction. This is what an entity would have to pay to replace a defaulted counterparty. 1 st Presenter 6.1: Explain how Figure 5.2 is like a call option. **Explain why equities is like a call option (EXAM)** p.67
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Version 1 Long-term supply agreements involve one party committing to sell a product for a long period of time and another one committing to accept deliveries and to make payments. The price is set at the inception of the agreement and is valid until termination. To avoid being exposed to the volatility of prices, Utility Co enters into long-term contracts (long-term supply agreements) with Traders & Co. Utility Co agrees to buy a predetermined amount from suppliers in exchange for the commitment to be delivered a given quantity of oil. The purpose is to eliminate their exposure to the fluctuations of the market price and their CFs are known in advance. Situations: • 100,000 oil per month need to be provided by the supplier. • Agreed price is at $3. • The contract valid for 5 years. 2 situations: CFs perspective, the price increase + increase the value (option) 1. From a CFs perspective, each money the company need to pay $300,000 to supplier in exchange of oil 2. If the price goes up to $4 due to strong economy, the company made a good deal because they pay $3 only whereas the market price is now $4. Traders & Co (supplier) ( loss )was caught off-guard by the large price increase in the market and due to a high volume of speculative bets, is going out of business and stops all deliveries immediately bankruptcy. Utility Co (the company) has no options and need to find another supplier. The graph shows the dollar loss for Utility Co according to the prevailing oil price. The extra cost is 100,000 x 12(months) x ($4 - $3) = $1.2 million, hence 4 years is 4 x $1.2m = $4.8m Therefore, the supply contract generated a credit risk for Utility Co because when Traders & Co defaulted, Utility Co suffered a financial loss, the reasons: • Agreed price ($3) • Remaining of the contract (4 years) • The market price at the time of Traders & Co default ($4)
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What creates the dynamic exposure is the fact that the magnitude of the credit exposure depends on the market price at the time of the default. Each time the price of the product underlying the agreement changes, the credit exposure changes.
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