Case 066Counterparty risk and CVAHard
A power company that earns only in rupees has a cross-currency swap with your bank in which it pays dollars and receives rupees on USD 100 million, and also owes USD 150 million of loans. The dollar rises 20% against the rupee. Show how your exposure and the client's default risk rise together, and propose limits and mitigants.
1The situation
Indrakant Power sells electricity under rupee tariffs; it has no dollar income. Three years ago it borrowed Rs 840 crore from rupee bondholders and entered a cross-currency swap with your bank on USD 100 million, receiving rupees to pay the bondholders and paying dollars at a lower coupon. It also has USD 150 million of dollar loans from other lenders. Its dollar debt service across both is about USD 35 million a year, against cash flow available for debt service of Rs 340 crore.
The rupee weakens so that a dollar costs 20% more: Rs 100.80 instead of Rs 84. Ignore coupons and discounting on the swap and value it at the change in the exchange rate on the notional.
2Your task
Show how the bank's exposure and Indrakant's default risk move together, quantify the expected loss, and propose limits and mitigants.
Quick check
Why is this swap more dangerous than one with the same exposure to an exporter earning dollars?
Worked solution
Try it on paper, then open one step at a time.
30-second answerThe answer to give first
This is wrong-way risk: the rupee fall that lifts the bank's swap exposure to about Rs 168 crore also pushes Indrakant's debt service cover from 1.16x to 0.96x, below one. Priced as if unrelated, expected loss at that rate is about Rs 1.0 crore; priced with the default probability that goes with it, about Rs 20 crore. Limit the swap on stressed exposure times stressed PD, require collateral or a capped structure, and never let a rupee-only earner run an open dollar position through the bank.
Step 1How does the bank's exposure move with the rupee?
Indrakant has promised to pay USD 100 million and receive the rupees it received at Rs 84. When a dollar costs Rs 100.80, the dollars it owes are worth Rs 1,008 crore against Rs 840 crore coming back, so the swap is worth about Rs 168 crore to the bank, all of it owed by Indrakant. The exposure grows by Rs 10 crore for every rupee the dollar gains.
Step 2What happens to the client at the same time?
Imagine lending money to a friend whose salary is in rupees but whose rent is in dollars. The day the rupee falls is the day he owes you more and can pay you less. Indrakant's dollar debt service rises from Rs 294 crore to Rs 352.8 crore a year while its rupee cash flow stays at Rs 340 crore, so debt service cover falls from 1.16x to 0.96x. Cover crosses one when a dollar costs about Rs 97. The USD 150 million of loans alone now cost Rs 252 crore more to repay in rupees. The same variable that grows the bank's claim shrinks the client's capacity to honour it; that is wrong-way riskWhen a counterparty is more likely to default precisely when the exposure to it is largest, because the same market move drives both..
Step 3How much bigger is the loss once the link is priced?
Take the stressed rate, Rs 100.8, and a loss given default of 60%. With today's 1% PD, as if the exposure and the default were unrelated, expected loss is Rs 168 crore x 1% x 60%, about Rs 1.0 crore; with an illustrative 20% PD for a borrower whose cover is below one, it is about Rs 20.2 crore, twenty times more. Standard counterparty models often multiply an exposure profile by a PD estimated separately, which is exactly the independent version. That is why wrong-way trades need to be identified by hand and priced on the joint scenario.
Step 4What limits and mitigants would you propose?
Start with suitability, then size, then protection. A borrower with no dollar income should not be paying dollars through the bank's swap book beyond any real dollar costs it needs to hedge; this trade created the exposure rather than hedging one. For existing trades, set the counterparty limit on exposure under a rupee stress multiplied by the PD in that stress, not today's PD. Ask for a collateral agreement with a low threshold, accepting that a stressed client may struggle to post; margin at least moves the bank's claim into cash early, while the client can still pay. Offer to restructure into a capped version, where Indrakant's dollar cost cannot rise beyond a set rate, or add break clauses at set dates. And look across the book: other rupee-only borrowers with dollar swaps create the same risk at once.
Where candidates lose it
The common miss is treating exposure and default as two separate numbers and multiplying them, which gives a small expected loss and a comfortable limit. The whole point of the case is that the rupee drives both.
The second is proposing collateral as the full answer. A client that cannot service its debt at Rs 100 to the dollar also struggles to post margin at Rs 100; collateral helps only if it is called early and often.
What the interviewer asks next
- How would the answer change if Indrakant exported half its power to a neighbouring country and was paid in dollars?
- How would you build a wrong-way stress scenario for a CVA desk?
- Indrakant asks to extend the swap by five years. What conditions would you set?
Company names and figures are illustrative.