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Measuring and Managing Default Risk

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Risk-based capital adequacy standards for derivative ... Netting by novation ... transaction requiring payment equal to difference between novated transactions ... – PowerPoint PPT presentation

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Title: Measuring and Managing Default Risk


1
Measuring and Managing Default Risk
  • Financial Risk Management
  • Chapter 17

2
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

3
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

4
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

5
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

6
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

7
Exposure over the Life of the Transaction
  • Amortization effect

Volatility 16.4 Rate 7
7
6
5
Replacement cost
4
3
2
1
3
2
1
4
5
6
7
Time
8
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

9
Combining Amortization Diffusion Effects
  • Produce Hump Shape
  • Figure 17-7
  • a Interest rate swaps
  • No Notional Principal Risk
  • b Currency swaps
  • Notional Principal Risk

10
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

11
Expected Exposure Use
  • Appropriate Credit Margin
  • Rate of Return for Risk Management

12
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

13
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

14
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

15
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

16
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.)

17
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

18
Methods for Reducing Credit Risk
  • Netting is simplest
  • Collateral
  • Third party support - Guarantee
  • Settlements, unwinds, assignments
  • Special purpose vehicles
  • nonconsolidation
  • capitalization
  • operating guidelines

19
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)

20
(No Transcript)
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