Derivative Credit Limit (PFE): a Worked Example

A forward exchange contract or an interest rate swap fixes a price for something that happens later. From the day it is struck its value moves with the market, sometimes in the client's favour and sometimes in the bank's. When the contract is worth money to the bank, the client owes that value in substance, and if the client failed the bank would have to strike the same contract with someone else at the worse market rate. The loss is the replacement cost.

Because that cost can grow, the bank treats the hedges as a credit exposure. It approves a limit through the same credit process as a loan, counts the usage in the client's total exposure and against its single-name limit, and commonly secures it under the same security as the lending: a general security agreement in New Zealand and Australia, a debenture in the UK. A business with a spotless repayment record can still find that it cannot hedge, because its line is full.

The add-on is the potential future exposure: an estimate, at a chosen level of confidence, of how much more the contract could come to be worth to the bank before it ends. Many banks use a table of factors by product and term for business clients; larger banks may simulate the client's portfolio instead. The shape differs by product. A forward's exposure tends to grow until its value date, because the whole exchange happens at the end. An interest rate swap's tends to peak partway through its life and fall as the remaining payments run off.

Two things reduce usage. Netting under a master agreement lets contracts in the bank's favour be set against those in the client's. Collateral posted under a credit support annex covers current exposure, though mid-market borrowers rarely post it. Capital rules measure the same risk in a parallel way, but not by one method. The Basel Committee's standardised approach for counterparty credit risk, which adds replacement cost to a potential future exposure add-on, has applied in the UK since 2022 and to Australia's IRB banks since 2023; Australia's other banks use an adjusted form of the older current exposure method, and New Zealand's capital rules still use a current exposure method with fixed add-on factors by term. A bank's internal limit may use a different method again.

A wool exporter, constructed for this page, sells US dollars forward to fix the value of its sales in its home currency. Its bank has approved a derivative credit limit of US$2.0m and applies factors of 4% for contracts maturing within six months, 7% for six to twelve months and 12% for twelve to twenty-four months. The factors and the limit belong to the example, not to any bank's table.

The exporter's board wants to hedge another US$6m of next season's clip, which it will be paid for in eighteen months:

Term, not size, decides it. The same US$6m uses three times as much of the line two seasons out as it does next quarter. The line can also fill with no dealing at all. If the US dollar strengthens 5% against the home currency, the existing US$28m book becomes worth about US$1.4m more to the bank, and usage rises to roughly US$3.07m. That rise is a limit excess to report and manage, even though the US dollar sales the forwards hedge are worth more to the exporter by a similar amount.

Current exposure is what the contracts are worth to the bank today, the mark-to-market when it is in the bank's favour. It can be zero on the day a hedge is struck. Potential future exposure is the margin the bank adds for what could happen before the contracts end, and it is why a line is used from the first day. A limit sized on current exposure alone would be full exactly when markets had moved most.

The line is also separate from the settlement limit, which covers the hours on value date when the bank has paid its side and not yet received the client's. One measures a fraction of every contract over its life; the other measures the whole of the contracts falling due on one day. Where the client's credit weakens as the exposure grows, as with an importer whose margins fall when its currency drops, the bank reads wrong-way risk as well.

DEFINED IN ONE PARAGRAPH → · PRODUCT FILE: FX FACILITY → · SETTLEMENT RISK →

The line has to match the client's hedging policy. A policy that requires cover eighteen months ahead needs a line sized for long-dated contracts, and a credit officer who approves the policy and then a line sized for six-month forwards has approved a policy the business cannot carry out. The gap is a credit risk of the bank's own making: the unhedged sales sit with the borrower.

When a client weakens, the line is often where the bank acts first, by holding new hedges to shorter terms or declining to extend the limit. And when a business moves its lending, the hedges stay with the old bank, are closed out, or are novated to the new lender, which has to approve a line of its own before it can take them on. The documents governing that, including the ISDA Schedule, decide what happens to them.

A FORWARD CONTRACT FOR AN EXPORTER → · THE ISDA SCHEDULE → · HEDGING POLICY →