Transcript Lecture 15

Lecture 15
Credit derivatives cont…
Summary of credit risk management
Operational risk
Total Return Swaps
• (TRS) are contracts where one party, called the
protection buyer, makes a series of payments linked to
the total return on a reference asset
• They are also called assets swaps, exchange,
• the protection seller makes a series of payments tied to
a reference rate, such as the yield on an equivalent
Treasury issue (or LIBOR) plus a spread.
• If the price of the asset goes down, the protection buyer
receives a payment from the counterparty
• If the price goes up, a payment is due in the other
direction
• This type of swap is tied to changes in the market
value of the underlying asset and provides
protection against credit risk
• The TRS has the effect of removing all the
economic risk of the underlying asset without
selling it.
• Example
• Suppose that a bank, call it Bank A, has made a $100 million loan
to company XYZ at a fixed rate of 10 percent. The bank can hedge
its exposure by entering a TRS with counterparty B, whereby it
promises to pay the interest on the loan plus the change in the
market value of the loan in exchange for LIBOR plus 50bp. If the
market value of the loan increases, bank A has to make a greater
payment. Otherwise, its payment will decrease, possibly becoming
negative.
Example cont…
• Say that LIBOR is currently at 9 percent and that after one year, the
value of the loan drops from $100 to $95 million. The net obligation
from Bank A is the sum of
• Outflow of 10% x $100 = $10 million, for the loan’s interest payment
• Inflow of 9.5% x $100 = $9.5 million, for the reference payment
• Outflow of (95-100)/100))% x $100 = -$5 million, for the movement
in the loan’s value
• This sums to a net receipt of 10- 9.5- (-5) = $5.5 million. Bank A has
been able to offset the change in the economic value of this loan by
a gain on the TRS
Credit Spread Forward and Options
• These instruments are derivatives whose value is
tied to an underlying credit spread between a
risky and risk-free bond
• In a CSF, the buyer receives the difference
between the credit spread at maturity and an
agreed-upon spread, if positive.
• Conversely, a payment is made if the difference is
negative
• In a Credit spread option, the buyer pays a
premium in exchange for the right to “put” any
increase in the spread to the option seller at a
predefined maturity
Example of credit spread option
• A credit spread option has a notional of $100 million with a
maturity of one year. The underlying security is an 8% 10-year
bond issued by the corporation XYZ. The current spread is 150bp
against 10-year Treasuries. The option is European type with a
strike of 160bp. Assume that, at expiration, Treasury yields have
moved from 6.5% to 6% and the credit spread has widened to
180bp
• The price of an 8% coupon, 9-year semiannual bond discounted at
y+S =6+1.8= 7.8% is $101.276.
• The price of the same bond discounted at y+K= 6 +1.6 =7.6% is
$102.574.
• Using the notional amount, the payout is (102,574 - 101,276)/100
x $100,000,000 = $1,297,237.
Credit risk management - Summary
• Pooling together all the previous points in credit risk
discussion, we can now summarize credit risk
management.
• Like VaR for market risk, credit VaR (CVAR)can be
measured and managed
• Credit VAR = WCL – ECL
• WCL is worst credit loss is the loss that will not be
exceeded at some level of confidence
• Unexpected loss is the difference between worst and
expected losses
• Most of the times, UCL depends on the distribution of
joint default rates (correlation), among other factors
Credit risk management - Summary
• Notably, the dispersion in the distribution narrows as
the number of credits increases and when correlations
among defaults decrease.
• Institutions should have enough capital to cover the
unexpected losses
• CVAR is measured over a target horizon, say one year
• The horizon is deemed sufficient for the institution to
take corrective actions should credit problems start to
develop
Credit risk management - Summary
• Corrective action can take the form of exposure
reduction or adjustment of economic capital, all of
which take considerably longer than the typical horizon
for market risk
• The portfolio manager can examine the credits that
contribute most to CVAR.
• If these credits are not particularly profitable, they
should be eliminated
Operational Risk
What is operational risk
• The risk of loss resulting from inadequate or
failed internal process, people, and system or
from external events
• Basel committee has identified several loss
categories
1. Internal fraud
Unauthorized activity, theft or fraud, that involves
at least one internal party -
Loss categories in operational risk
2. External fraud
Refers to theft or fraud carried out by a third party
outside the organization – theft, robbery,
compute hacking, theft of information
3. Employment practices and workplace safety
-employees compensation claims, wrongful
termination, volition of safety and health rules,
discrimination claims, harassment
Loss categories in operational risk
4. Clients, products, and business practices –
Losses arising from a failure to meet an obligation
to a client, or from nature or design of products
– Misuse of confidential clients’ information
– Money laundering
– Product defects
– Exceeding clients exposure limits
5. Damage to physical assets
Losses arising out of disaster or other events – natural
disasters, terrorism or vandalism
Loss categories in operational risk
6. Business disruption and system failures
-hardware and software failures
-Telecommunications problems
-Power outages/disruptions
7. Execution, delivery, and process management
-risk associated with transaction processing, trade
counterparties for example, miscommunication,
data entry errors, accounting errors, vendor
disputes, outsourcing
According to Basel II, banks must hold capital for
operational risk that is equal to the average of
the previous three years of a fixed percentage (α)
of positive annual gross income, which means
that negative gross income figures must be
excluded
• where K is the capital charge
• Y positive gross income over the previous three
years
• and n the number of the previous three years for
which gross income is positive
• The fraction α is fixed by the Basel Committee at
15 percent
• For the purpose of estimating K, the Committee
defines gross income as net interest income plus
net non-interest income as defined by the
national supervisors and/or national accounting
standards
• The Committee suggests that the recognition of Y
requires the satisfaction of the following criteria:
(i) being gross of any provisions,
• (ii) being gross of operating expenses,
• (iii) excluding realized profi ts/losses from the sale
of securities, and
• (iv) excluding extraordinary and irregular items
as well as income from insurance claims.
The Standardized Approach
• Accepting that some financial activities are more
exposed than others to operational risk (at least
in relation to gross income), the BCBS divides
banks’ activities into eight business lines.
• The capital charge for each business line is
calculated by multiplying gross income by a factor
(β) that is assigned to each business line.
• (β) is essentially the loss rate for a particular
business line with an average business and
control environments.
• The total capital charge is calculated as a threeyear average of the simple sum of capital charges
of individual business lines in each year
• Hence
Where j is set by the Basel Committee to relate the
level of required capital to the level of gross
income for business line j.
Examples of activities falling under business lines
Examples of activities falling under business lines
The advanced measurement approach
• The BCBS (2004a) suggests that if banks move
from the BIA along a continuum toward the AMA,
they will be rewarded with a lower capital charge
• The BCBS makes it clear that the use of the AMA
by a certain bank is subject to the approval of the
supervisors.
• The regulatory capital requirement is calculated
by using the bank’s internal operational risk
measurement system.
• The Committee considers insurance as a mitigator
of operational risk only under the AMA
• Under this approach, banks must quantify
operational risk capital requirements for seven
types of risk and eight business lines, a total of 56
separate estimates
• The Basel II accord allows three alternative
approaches under the AMA:
• (i) the loss distribution approach (LDA);
• (ii) the scenario-based approach (SBA); and
• (iii) the scorecard approach (SCA), which is also
called the risk drivers and controls approach
(RDCA).
• The three approaches differ only in the emphasis
on the information used to calculate regulatory
capital