How Do I Assess Credit Risk in Derivatives?

Derivatives are financial instruments whose value depends on the underlying underlying asset price, such as forwards, futures, options, swaps, etc. Since the 1980s, financial markets have been turbulent, unpredictable, and market risks have increased day by day. Derivatives have developed rapidly due to their huge role in finance, investment, hedging, and interest rate behavior, especially enriching and expanding banks' off-balance sheet business. However, these derivatives, which are designed to avoid market risks, contain new credit risks. For example, interest rate swaps and currency swaps can reduce interest rate risk, but they must bear the default risk of the swap counterparty. If the bank is only involved in the swap business as the intermediary and guarantor of the swap, any breach of the contract by the party will be borne by the bank.

Credit Rating Derivatives Risk Measurement

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Derivatives are financial instruments whose value depends on the underlying underlying asset price, such as forwards, futures, options, swaps, etc. Since the 1980s, financial markets have been turbulent, unpredictable, and market risks have increased day by day. Derivatives have developed rapidly due to their huge role in finance, investment, hedging, and interest rate behavior, especially enriching and expanding banks' off-balance sheet business. However, these derivatives, which are designed to avoid market risks, contain new credit risks. For example, interest rate swaps and currency swaps can reduce interest rate risk, but they must bear the default risk of the swap counterparty. If the bank is only involved in the swap business as the intermediary and guarantor of the swap, any breach of the contract by the party will be borne by the bank.
In addition, in the over-the-counter options trading, the default risk is also increasing. Therefore, the management of the credit risk of derivatives has also received increasing attention from financial regulatory authorities in various countries. In principle, the methods discussed earlier are still useful for the prediction of derivative credit risk. Because, an important factor that causes contract breach is usually the other party's financial difficulties. Nevertheless, there are still many subtle differences in the default risk of loans, OTC transactions and off-balance sheet derivatives. First of all, even if the other party is in financial distress, it is only possible to breach a contract with a bad value (a contract that brings negative value in performance) and try to fulfill all the real value contracts (a contract that brings positive value). Secondly, at any level of default probability, the losses suffered by default of derivative instruments are often lower than the losses of loan default.
Chinese name
Credit Rating Derivatives Risk Measurement
Foreign name
Credit Rating derivatives risk measurement method
Nature
Economic terms
Classification
Risk exposure equivalent method, simulation method
classification
The credit rating derivative risk measurement method mainly focuses on options and swaps, the most representative of which are the following three.
(I) Risk exposure equivalent method (Riskequivalentexposure (REE)
The risk exposure equivalent method (REE) is a core method that runs through the credit risk measurement of derivatives. This type of method aims to estimate the value of credit risk exposure, considers the intrinsic value and time value of derivative instruments, and establishes a series of REE calculation models with a special method of risk coefficient. There are both REE models based on the nominal principal and contract value of derivative transactions, and REE models based on derivative types and portfolio strategies. Among them, the risk factor is the core instrument that converts the nominal principal of a derivative transaction into an equivalent risk exposure. Based on the investor's risk appetite, the four concepts of risk exposure equivalent can be calculated, that is, the equivalent value of maturity risk exposure, the equivalent value of average risk exposure, the equivalent value of worst-case risk exposure, and the equivalent value of expected risk exposure. To measure the level of credit risk.
(Two) simulation method
Simulation is a computer-intensive statistical method. The Monte Carlo simulation process is used to simulate the possible paths of key random variables that affect the value of derivatives and the value of derivatives at various points in time or at the time of trading. After hundreds and hundreds of iterations, an average is obtained. The difference between the initial value of the derivative and the simulated average is a measure of the value of the credit risk exposure at any future point in time and at maturity.
(Three) sensitivity analysis method
Derivative traders usually use some comparison coefficients in derivative value models, such as Delta, Gamme, Vega and Theta to measure and manage the risk of positions and trading strategies. Sensitivity analysis is to use these comparative values to estimate the value of derivatives through scenario analysis or the application of risk coefficients. Delta is used to measure the sensitivity of the price of derivative securities to changes in the price of the underlying asset. Gamme measures the sensitivity of the delta value of the derivative securities to changes in the price of the underlying asset. It is equal to the second-order bias of the price of the derivative securities to the price of the underlying asset. The derivative is also equal to the first-order partial derivative of the delta asset price of the derivative securities. Vega is used to measure the sensitivity of the value of derivative securities to the volatility of the underlying asset price; Theta is used to measure the sensitivity of the value of derivative securities to changes in time. The ultimate purpose of the sensitivity analysis method is still to estimate the risk exposure equivalent value (REE). Only the coefficients used in the estimates are different. For example, Ong mainly uses Delta and Gamme to estimate REE, and Mark uses all the above coefficients, and uses program analysis to obtain the new value of derivatives.

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