Managing maturity mismatches

A bank purchasing credit protection is exposed to credit risk if the maturity of the
credit derivative is less than the term of the exposure. In such cases, the bank would
face a forward credit exposure at the maturity of the derivative, as it would no longer
have protection. Hedging banks should carefully assess their contract maturities to
assure that they do not inadvertently create a maturity mismatch by ignoring material
features of the loan. For example, if the loan has a 15-day grace period in which the
borrower can cure a payment default, a formal default can not occur until 15 days
after the loan maturity. A bank that has hedged the exposure only to the maturity
date of the loan could find itself without protection if it failed to consider this grace
period.
In addition, many credit-hedging transactions do not cover the full term of the
credit exposure. Banks often do not hedge to the maturity of the underlying exposure
because of cost considerations, as well as the desire to avoid short positions that
would occur if the underlying obligor paid off the bank’s exposure. In such cases,
the bank would continue to have an obligation to make fee payments on the default
swap, but it would no longer have an underlying exposure.