How can I assess credit risk in derivatives?

When assessing credit risk in derivatives, investors must deal with two types of credit exposure, current exposure and potential exposure. The price of the Mark-to-Market of the Contract, which indicates the costs of compensation in the event of a counterparty failure, determines its current credit risk. Investors can calculate estimates of future replacement costs or potential exposures using various analytical probability analytical tests, such as option valuation models, historical simulation studies and Monte Carlo studies. These tests provide two ways to estimate potential exposure, maximum exposure and expected exposure. The credit risk in derivatives changes throughout the life of the contract as a variable change of the basic contract.

The current credit risk in derivatives is the simplest completion analysis, as the current value of the contract determines the current exposure. For example, if an investor enters the US dollar $ 200 million (USD), the five airline rate in which the counterparty pays him PEThe value of five percent and pays the counterparty of the floating rate of the London interbank rate (Libor), then the current costs at the time of execution are zero. The value of the brand on the four -year swap market is 4.25 percent a year later. If the counterparty is a default one year in the contract, the current exposure or exchange costs of 0.75 percent per year for four years and any due payment due.

Credit risk in derivatives can also be assessed by replication of volatility of basic variables such as commodity prices, stock prices and exchange exchange rates and simulate the effect of such shifts to the derivative value. The investor can model the maximum potential risk of examining such extreme adverse movements in basic variables, that it would be highly unloche, that the situation may be worse than the maximum expected risk. The expected exposure, on the other hand, deals with the best estimates of the realon the risks using historical data, patterns of cash flows of the underlying asset and the nature of the derivative involved. Estimated values ​​for both maximum and expected exposures can be plotted on a graph with a percentage of risk value on the Y axis and years have passed on the X -axis. Such credit risk graphs in derivatives show a concave or bump curve that begins with the risk of zero percent.

When the credit risk in derivatives is taken over time, the concave configuration of the curve stems from two contradictory forces. Initially, the curve increases and the credit risk increases for the period due to the diffusion effect, ie the tendency of variables to change significantly from the initial value. However, this force is alleviated over time by an amortization effect in which the impact of variable changes decreases when the contract is close to its expiration date. In other words, the passage of time increases the likelihood that the cost of reimbursement will increase, but it is compensated by the fact that the course of time decreases the years during which By had to be replaced by any lost cash flow.