Credit risk is connected with the possibility that an outstanding currency position may not be repaid as agreed, due to a voluntary or involuntary action by a counter party.
The following forms of credit risk are known:
- Replacement risk occurs when counter parties of the failed bank find their books unbalanced to the extent of their exposure to the insolvent party. To rebalance their books, these banks enter new transactions.
- Settlement risk occurs due to different time zones on different continents, so currencies may be credited at different times during the day. For example, Australian and New Zealand dollars are credited first, then Japanese yen, followed by the European currencies and ending with the U.S. dollar. Therefore, payment may be made to a party that will declare insolvency (or be declared insolvent) immediately after, but prior to executing its own payments.
The credit risk for instruments traded off regulated exchanges is to be minimized through the customers' creditworthiness. Commercial and investment banks, trading companies, and banks' customers must have credit lines with each other to be able to trade. Even after the credit lines are extended, the counter parties’ financial soundness should be continuously monitored. Along with the market value of their currency portfolios, end users must consider also the
potential portfolios exposure. The latter may be determined through probability analysis over the time to maturity of the outstanding position. Netting is used for the same purposes. Netting
is a process that enables institutions to settle only their net positions with one another, not trade by trade, but at the end of the day, in a single transaction. If signs of payment difficulty of a bank are shown, a group of large banks may provide short-term backing from a common reserve pool.
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