Measuring and Managing Default Risk

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Measuring and Managing Default Risk

• Financial Risk Management
• Chapter 17

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Importance of Default Risk

• Risk-based capital adequacy standards for
  derivative transactions
• Outgrowth of Basle Committee on Banking
  Supervision
• Representatives from Central Banks of
• Belgium, Canada, France, Germany, Italy, Japan,
  the Netherlands, Sweden, United Kingdom, the
  United States, (G-10) plus Switzerland and
  Luxembourg

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Options

• Default risk is one sided - option buyer cannot
  default
• Seller has obligation to perform
• Can default only if
• option is in the money
• court releases seller from contractual obligation
• Default risk of an option can itself be seen as
  an option

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Option to Default

• Compound option
• value of the underlying option
• credit standing of the seller of the option
• correlation between the underlying financial
  price and the value of the option sellers other
  assets

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Risk Measuring

• Risk based on the potential default induced loss
  is function of
• Exposure the amount at risk
• Probability of default the likelihood of a loss
• Potential default-induced loss
• Exposure x Probability of default

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Exposure

• Measuring derivatives exposure differs from
  measuring credit risk exposure
• Not only the current value of the derivative
  matters, but also all potential changes in value
• Exposure changes over the life of the transaction

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Exposure over the Life of the Transaction

• Amortization effect

Volatility 16.4 Rate 7
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Replacement cost
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Time
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Exposure over the Life of the Transaction

• Diffusion effect
• exposure influenced by degree to which underlying
  price can differ from price at contract
  origination
• function of time remaining until contract maturity

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Combining Amortization Diffusion Effects

• Produce Hump Shape
• Figure 17-7
• a Interest rate swaps
• No Notional Principal Risk
• b Currency swaps
• Notional Principal Risk

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Maximum vs. Expected Exposure

• Loan contract both are the same
• Derivative instrument exposures differ
• Maximum exposure
• greatest exposure investor can lose if
  counterparty defaults
• set as alarm level
• Expected exposure
• ex-ante measure of how much investor could expect
  to lose

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Expected Exposure Use

• Appropriate Credit Margin
• Rate of Return for Risk Management

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Measuring Individual Transaction Exposure

• Worst case approach
• conservative high and low projections
• assume the worst outcome for the investor from
  both the diffusion and amortization processes

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Measuring Individual Transaction Exposure

• Simulation approach
• Monte Carlo simulation
• Option valuation approach
• default risk as an option
• Capital Adequacy rules - Basle Committee
• Potential Exposure
• Notional Principal x Credit Conversion Factor

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Measuring Portfolio Exposure

• General portfolio effect
• exposure of sum is less than sum of individual
  exposures
• Investor may be able to net her exposures
• OTC derivatives netted on bilateral basis mostly

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Netting

• Netting by novation
• matched pairs of transactions (same underlying,
  same settlement date) deemed terminated and
  replaced by single transaction requiring payment
  equal to difference between novated transactions
• common in FX spot and forward transactions

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Netting

• Closeout netting
• operative only for the event of default
• positive and negative contract values for
  particular counterparty are netted
• standard form of handling defaults
• Cross product netting
• netting across products - with the same
  counterparty (Interest Currency e.g.)

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Measuring Probability of Default

• 4 factors determine probability of default for
  individual risk management transaction
• creditworthiness of couterparty
• maturity of the transaction
• counterpartys inherent exposure to movement in
  underlying financial price
• volatility of underlying financial price

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Methods for Reducing Credit Risk

• Netting is simplest
• Collateral
• Third party support - Guarantee
• Settlements, unwinds, assignments
• Special purpose vehicles
• nonconsolidation
• capitalization
• operating guidelines

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Settlement Risk

• Exists when simultaneous exchange in transaction
  is required
• Few transactions are settled on same-day basis
• Reduced by payment netting provisions
• Largest source of settlement risk - foreign
  currency trades (Herstatt Bank)

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