Credit risk exposure with interest and currency swaps

2019

In this thesis, the risk measures expected shortfall (ES), potential future exposure (PFE) and expected positive exposure (EPE) are studied in the context of counterparty exposure for a pay floating –receive fixed swap contract. The HeathJarrow-Morton framework for modelling interest rates is used to generate future market scenarios by Monte Carlo simulation. Further, the simulated future interest rates are used to price an interest rate swap at every simulated time step in the lifetime of the swap. Finally, the collection of simulated swap prices is used to generate values for the counterparty exposure, represented by the risk measures ES, PFE, and EPE. The performance of the measures were tested during different periods between 2005 and 2019, with interest rate data going back to 2002. Results show that the ES measure performs better than PFE, but none of them are fully able to capture the actual exposure during periods of market stress, such as the financial crisis of 2008. A shi...

Journal of Banking & Finance, 1997

Currency and interest rate swaps are subject to a complex, two-sided default risk. Although several theoretical papers have recently addressed the problem of pricing swap credit risk, the empirical literature is almost non-existent. This is the only study we know which uses actual transaction data to document the effect of credit risk on swap spreads. We provide results for both interest rate and currency swaps.

2016

The thesis can be placed within the literature on market and counterparty credit risk, contributing along the following three dimensions: 1. Interest rate risk (IRR) management: The thesis starts with an overview on asset liability management (ALM) in general and IRR management in particular. It then gives a novel procedure for structuring swap overlays for pensions funds, allowing for optimal hedging of IRR without affecting the strategic asset allocation (SAA). The thesis also offers an extension of the analysis of the Cairns (2004) stochastic interest rate model Deriving respective model-based sensitivity measures (Cairns deltas). It finally applies the model to a practical application, analyzing it when it comes to long-term contracts. 2. Pricing and managing counterparty credit risk A compact overview on counterparty credit risk (CCR) and credit valuation adjustment (CVA) is given. This is followed by a unique analyses around valuation, relevant accounting and regulatory requir...

European Financial Management, 1998

The concept of "value-at-risk" (VAR) -the maximum loss on a specified horizon date at a given level of confidence -is widely used at various levels of the financial system. Individual traders and trading desks use the concept to determine the range of their potential gains and losses over the next trading day. The managers of financial institutions apply the notion of VAR to measure and control the risks of traders. Regulatory authorities, concerned with the stability of the financial system and of the institutions under their jurisdiction, set capital adequacy standards based on measures of VAR. No matter what the specific criteria for disclosure and capital adequacy are, a financial intermediary needs to translate the regulatory requirements into a practical system for implementation. The system needs to take into account market data such as interest rates and exchange rates, as well as the detailed characteristics of the portfolio of assets and liabilities held by the intermediary, in order to value the portfolio on future dates and measure its response to changes in the market prices.

1997

The interest rate swap market has grown rapidly. Since the inception of the swap market in 1981, the outstanding notional principal of interest rate swaps has reached a level of $12.81 trillion in 1995.

1999

Currency and interest rate swaps are subject to a complex, two-sided default risk. Several theoretical papers have addressed the problem of pricing swap credit risk. I propose a complete implementation procedure of the structural line of research in theoretical credit risk analysis in order to attempt to evaluate an OTC contract such as the swap contract. It is shown how structural models can enable us to extract the whole credit risk information from scarce data if of good quality, which leads to the problem of mixing accounting and available financial data from traded prices. Ther analytical results are therefore benchmarked against actual transaction data. Although the results are not very satisfactory for swap pricing, the procedure provides interesting insights in some parameter estimations linked to the credit worthiness of the firm that show to be consistent indicators, useful for credit risk management purposes.

Credit derivatives are an up to date innovation in financial markets. These financial instrument have a potential to allow enterprises to trade and manage the credit risks and market risks. The striking growth of credit derivatives suggest that participant of financial markets find them to be useful instrument for risk management. The most popular and fundamental credit derivatives is a credit default swaps (CDS). In the paper we detailed the risk management of the credit default swaps and quantified the credit risk of investors in two way: (i) calculate the term structure of default probabilities from the market prices of traded CDS and (ii) calculate prices of CDS from the probability distribution of the time-to-default

The Journal of Finance, 1996

This article presents a model for valuing claims subject to default by both contracting parties, such as swaps and forwards. With counterparties of different default risk, the promised cash flows of a swap are discounted by a switching discount rate that, at any given state and time, is equal to the discount rate of the counterparty for whom the swap is currently out of the money (that is, a liability). The impact of credit-risk asymmetry and of netting is presented through both theory and numerical examples, which include interest rate and currency swaps. THIS ARTICLE PRESENTS A model for valuing claims subject to default by both contracting parties, such as swaps and forwards. This extends the valuation model for defaultable claims proposed by Duffle and Singleton (1994) to cases in which the two counterparties have asymmetric default risk. The extension permits a reexamination of the impact of credit risk on swap rates. While the valuation model applies to all forms of contingent claims in which both contracting parties are at risk to default, such as forward contracts, we focus on swaps for purposes of illustration. For example, consider a 5-year interest rate swap between a given party paying a floating rate such as the London Inter Bank Offered Rate (LIBOR) and another counterparty paying a fixed rate. Replacing the given fixed-rate counterparty with a "lower-quality" counterparty, whose bond yields are 100 basis points higher, increases the swap rate by roughly 1 basis point, using our model and typical parameters for LIBOR rate processes. This credit impact on swap rates is approximately linear within the range of normally encountered credit quality. For a 5-year currency swap, given a foreign exchange rate with 15 percent volatility, our model shows the impact of credit risk asymmetry on the market swap rate to be roughly 10-fold greater than that for interest rate swaps; that is, approximately 10 basis points in swap rate per 100 basis points in bond yield credit spread. The main goal of this article is to provide a simple and theoretically consistent model allowing such computations.

Finance Research Letters, 2007

In this paper, we test the influence of various fundamental variables on the pricing of credit default swaps. The theoretical determinants that are important for pricing credit default swaps include the risk-free rate, industry sector, credit rating, and liquidity factors. We suggest a linear regression model containing these different variables, especially focusing on liquidity factors. Unlike bond spreads which have been shown to be inversely related to liquidity (i.e., the greater the liquidity, the lower the spread), there is no a priori reason that the credit default swap spread should exhibit the same relationship. This is due to the economic characteristics of a credit default swap compared to a bond. Our empirical result shows that all the fundamental variables investigated have a significant effect on the credit default swap spread. Moreover, our findings suggest that credit default swaps that trade with greater liquidity have a wider credit default swap spread.