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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

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Lecture 15

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  1. Lecture 15 Credit derivatives cont… Summary of credit risk management Operational risk

  2. 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

  3. This type of swap is tied to changes in the market value of the underlying asset and provides protection against credit risk

  4. 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.

  5. 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

  6. 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

  7. 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

  8. 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.

  9. 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

  10. 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

  11. 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

  12. Operational Risk

  13. 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 -

  14. 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

  15. 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

  16. 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

  17. 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

  18. 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

  19. 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.

  20. 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.

  21. The total capital charge is calculated as a three-year 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.

  22. Examples of activities falling under business lines

  23. Examples of activities falling under business lines

  24. 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.

  25. 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

  26. 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

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