Explain how off-balance-sheet market contracts, or derivative instruments, differ from contingent guaranty contracts.
Off-balance-sheet contingent guaranty contracts in effect are forms of insurance that FIs sell to assist customers in the financial management of the customers’ businesses. FI management typically uses market contracts, or derivative instruments, to assist in the management of the FI’s asset and liability risks. For example, a loan commitment or a standby letter of credit may be provided to help a customer with another source of financing, while an over-the-counter interest rate swap likely would be used by the FI to help manage interest rate risk.
a. What is counterparty credit risk?
b. Why do exchange-traded derivative security contracts have no capital requirements?
c. What is the difference between the potential exposure and the current exposure of over-the-counter derivative contracts?
d. Why are the credit conversion factors for the potential exposure of foreign exchange contracts greater than they are for interest rate contracts?
e. Why do regulators not allow DIs to benefit from positive current exposure values?