Topics 31-34 Flashcards
Describe wrong-way risk and contrast it with right-way risk
- Wrong-way risk (WWR) is an outcome of any association, dependence, linkage, or interrelationship between exposure and counterparty creditworthiness that generates an overall increase in counterparty risk and, therefore, an increase in the amount of the credit value adjustment (CVA). WWR also results in a reduction of the debt value adjustment (DVA). WWR can be hard to determine due to difficulties assessing the relationship among variables and the lack of relevant historical data.
- Right-way risk (RWR) is just the opposite of WWR. That is, any dependence, linkage, or interrelationship between the exposure and default probability of a counterparty producing an overall decrease in counterparty risk is described as RWR. RWR decreases the CVA and increases the DVA.
- Hedges, in normal functioning markets, should automatically generate RWR because the fundamental purpose of hedges is to curtail counterparty risk.
- Markets and numerous interactions (e.g., market credit interaction) do not always produce normal behavior, as evidenced by the recent global financial crisis. Those who were seeking protection against the default of debt issuers (e.g., on collateralized debt obligations) became victims of WWR when unfavorable interaction between exposures and insurers’ default probabilities (which were supposed to provide protection) intensified the amount of counterparty credit risk.
- Note that credit quality increases actually increase WWR. This is because counterparties with high credit quality are less likely to default. As a result, the occurrence of a default by a counterparty with high credit quality is less expected than a default by a counterparty with low credit quality.
Identify examples of wrong-way risk and examples of right-way risk
- It is estimated that conditional expected exposure will increase if the exposure (e.g., value of a forward contract) and the default probability of the counterparty are positively correlated, exhibiting WWR. On the other hand, negative correlation in this instance will lower the conditional expected exposure, showing RWR.
- The overall counterparty risk stems from a situation in which the counterparty credit quality is linked with macro (and global) factors that also impact the exposure of transactions.
Example of Over-the-Counter Put Option
- Out-of-the money put options have more WWR than in-the-money put options. Macroeconomic events (such as interest rates, inflation, industry- and sector-specific factors, or global factors) may deteriorate the creditworthiness of the counterparty, increasing the default probability. The same factors may trigger a fall in the underlying (e.g., stock) assets price, generating positive payoffs for the long but increasing the counterparty risk exposure.
Discuss the impact of wrong-way risk on collateral and central counterparties
- When exposure is increasing significantly, it’s important to evaluate the overall impact of collateral on WWR.
- With a jump in exposure, such as a currency devaluation associated with a sovereign default, it is much more difficult to receive collateral in a timely fashion.
- Since WWR tends to increase with increasing levels of credit quality, it could be argued that CCPs should demand higher levels of margin and default fund contributions from those members with higher credit quality.
- In addition, the collateral accepted by the CCP may also carry WWR. Some members may choose to post risky and illiquid assets as collateral, which may create higher levels of WWR for the CCP. One way to mitigate this practice is for the CCP to impose higher haircuts on specific assets that are accepted as collateral.
Differentiate among current exposure, peak exposure, expected exposure, and expected positive exposure
Four important definitions of exposure measures:
Current exposure. Also called replacement cost, current exposure is the greater of (1) zero or (2) the market value of a transaction (or a portfolio of transactions) that would be lost if the counterparty defaulted and no value was recovered during bankruptcy.
Peak exposure. Peak exposure measures the distribution of exposures at a high percentile (93% or 99%) at a given future date prior to the maturity of the longest maturity exposure in the netting group. Peak exposure is usually generated for many future dates.
Expected exposure. Expected exposure measures the mean (average) distribution of exposures at a given future date prior to the maturity of the longest maturity exposure in the netting group. Expected exposure is also typically generated for many future dates.
Expected positive exposure (EPE). EPE is the weighted average of expected exposures over time. The weights represent the proportion of individual expected exposures of the entire time interval. For the purposes of calculating the minimum capital requirement, the average is measured over the first year or over the length of the longest maturing contract.
Potential Future Exposure (PFE)
Potential Future Exposure (PFE) is the maximum expected credit exposure over a specified period of time calculated at some level of confidence (i.e. at a given quantile).
PFE is a measure of counterparty risk/credit risk. It is calculated by evaluating existing trades done against the possible market prices in future during the lifetime of transactions. It can be called sensitivity of risk with respect to market prices. The calculated expected maximum exposure value is not to be confused with the maximum credit exposure possible. Instead, the maximum credit exposure indicated by the PFE analysis is an upper bound on a confidence interval for future credit exposure.
Effective expected exposure (effective EE)
Measures such as EE and EPE may underestimate exposure for short-dated transactions (since capital measurement horizons are typically 1-year) and not capture properly rollover risk.
For these reasons, the terms effective EE and effective EPE were introduced by the Basel Committee on Banking Supervision (2005).
- Effective EE is simply a non-decreasing EE.
- Effective EPE is the average of the effective EE.
Explain the treatment of counterparty credit risk (CCR) both as a credit risk and as a market risk and describe its implications for trading activities and risk management for a financial institution.
- The treatment of CCR as a market risk was historically done through pricing in a credit valuation adjustment (CVA). CVA represents the market value of the CCR.
- Treating CCR as credit risk exposes an institution to changes in CVA. CVA should, therefore, be included in valuing a derivatives portfolio, otherwise the portfolio could experience large changes in market value.
- Treating CCR as market risk allows an institution to hedge market risk losses; however, it leaves the institution exposed to declines in counterparty creditworthiness and default.
- Treating CCR as both credit risk and market risk is prudent, but this approach is complex and difficult to interpret.
Describe a stress test that can be performed on a loan portfolio and on a derivative portfolio
Financial institutions apply current exposure stresses to each counterparty by repricing portfolios under a scenario of risk-factor changes. Counterparties with the largest current exposures and largest stressed current exposures are typically reported to senior management. The different stress scenarios would likely include different counterparties.
Stress tests of current exposure suffer from two main shortcomings:
- Aggregating stress results needs to incorporate additional information for it to be meaningful. Simply taking the sum of all exposures only looks at a loss that would occur if all counterparties were to simultaneously default, which is an unlikely scenario. In addition, the stressed current exposures do not factor in the credit quality of the counterparty. The stress results, therefore, only look at the trade values and not the counterparty’s capacity or willingness to repay its obligations.
- The stress results of current exposure also do not provide information on wrong-way risk. Since the stress measures already omit the credit quality of the counterparty, they cannot provide meaningful information on the correlation of exposure with credit quality.
Describe a stress test that can be performed on CVA. Calculate the stressed CVA and the stress loss on CVA.
- Stress testing CCR for market risk events looks at the losses in market value of a counterparty exposure due to market risk events or credit spread changes. Financial institutions typically only consider the unilateral CVA for stress testing, which looks at a counterparty’s default to the institution under various market events. However, financial institutions should also consider the possibility that they could default to their counterparties, and, as a result, should consider their bilateral CVA (BCVA).
- Calculating a stressed CVA involves applying an instantaneous shock to these market variables, which could affect the discounted expected exposure or the risk-neutral marginal default probability.
- Stress testing CCR in a credit-risk framework has similarities with stress testing in a market-risk framework.
- Both rely on EL as a function of LGD, exposure, and PD.
- Nevertheless, their values will differ depending on whether the view is from a market-risk or credit-risk perspective.
- The two primary differences include the use of risk-neutral values for CVA (versus physical values for ELs), and the use of ELs over the transaction’s life for CVA (versus a specific time horizon for ELs).
- In addition, CVA uses a market-based model for calculating the PD. The market-based approach has the advantage of being able to incorporate a correlation between the exposure and the PD. This correlation can significantly influence the CVA. Because there is uncertainty regarding the correlation, financial institutions should run stress tests to determine the effects on profit and loss from incorrect correlation assumptions.
Calculate the DYA and explain how stressing DVA enters into aggregating stress tests of CCR
Financial institutions should include the liability effects in their stress calculations to properly calculate the CVA profit and loss. As a result, institutions could adequately incorporate the value of their option to default to a counterparty through the bilateral CVA. This component is often called the debt value adjustment (DVA).
The probability of survival depends on credit default swap (CDS) spreads, and the losses depend on the financial institution’s own credit spread. Institutions should be aware that this may result in counterintuitive results, for example, implying that losses occur because the institution’s credit quality has improved. In any case, the financial institution should consider stress results for the BCVA and calculate stress losses by subtracting the current BCVA from the stressed BCVA.
The benefit of incorporating BCVA is that it allows CCR to be treated as market risk, which enables CCR to be included in market risk stress testing consistently. Any gains or losses from the BCVA stress could then be added to the institution’s stress tests from market risk.
Describe the common pitfalls in stress testing CCR
Stress testing CCR includes the following pitfalls:
- Stress testing CCR is a relatively new method, and institutions typically do not aggregate CCR with loan portfolio or trading position stress tests.
- Institutions typically stress test current exposure when incorporating the losses with loan or trading position. This is a mistake, because institutions should instead use expected exposure or positive expected exposure.
- Using current exposure can lead to significant errors, which is particularly evident in at-the-money exposures when measuring derivatives market values.
- When calculating changes in exposures, using delta sensitivities is also challenging for CCR since delta is nonlinear. The linearization of delta sensitivities in models can lead to significant errors.
Analyze the credit risks and other risks generated by retail banking
Although credit risk is the primary risk in retail banking, several other risks also impact the industry. These risks include:
- Operational risks: day-to-day risks associated with running the business.
- Business risks: strategic risks associated with new products or trends and volume risks associated with measures like mortgage volume when rates change.
- Reputation risks: the bank’s reputation with customers and regulators.
- Interest rate risks: the bank provides specific interest rates to its assets and liabilities and rates change in the marketplace.
- Asset valuation risk: a form of market risk associated with the valuation of assets, liabilities, and collateral classes. An example includes prepayment risk associated with mortgages in decreasing rate environments. Valuation risk also exists in situations when car dealers assume a residual value for a vehicle at the end of the life of a lease.
Explain the differences between retail credit risk and corporate credit risk
- There are several features that distinguish retail credit risk from corporate credit risk.
- As mentioned earlier, retail credit exposures are relatively small as components of larger portfolios such that a default by any one customer will not present a serious threat to a lending institution. Due to the inherent diversification of a retail credit portfolio and its behavior in normal markets, estimating the default percentage allows a bank to effectively treat this loss as a cost of “doing business” and to factor it into the prices it charges its customers. A commercial credit portfolio is subjected to the risk that its losses may exceed the expected threshold, which could have a crippling effect on the bank.
- Banks will often have time to take preemptive actions to reduce retail credit risk as a result of changes in customer behavior signaling a potential rise in defaults. These preemptive actions may include marketing to lower risk customers and increasing interest rates for higher risk customers. Commercial credit portfolios typically don’t offer these signals, as problems might not become known until it is too late to correct them.
Discuss the “dark side” of retail credit risk and the measures that attempt to address the problem
An unexpected, systematic risk factor may cause losses to rise beyond an estimated threshold, damaging a bank’s retail portfolio through declines in asset and collateral values and increases in the default rate. This represents the “dark side” of retail credit risk.
Primary causes include:
- The lack of historical loss data due to the relative newness of specific products.
- An across the board increase in risk factors impacting the economy overall that causes retail credit products to behave unexpectedly.
- An evolving social and legal system which may inadvertently “encourage” defaults.
- An operational flaw in the credit process due to its semi-automated structure that results in credit granted to higher risk individuals.
The Consumer Financial Protection Act (CFPA), in an attempt to manage the dark side of retail credit risk, requires credit originators to evaluate qualified mortgages and ability to repay.
A borrower with a “qualified mortgage” is assumed to have the capacity to repay. A qualified mortgage will put a limit on the amount of income allocated to debt repayments (e.g., debt-to-income ratio < 43%). A qualified mortgage cannot have excess upfront fees and points, may not be balloon payment loans or interest-only loans, may not be for longer than 30 years, and may not be negative amortization loans.
When a lender is evaluating a customer’s “ability to repay” the following underwriting standards must be considered:
- Credit history.
- Current income and assets.
- Current employment status.
- Mortgage monthly payments.
- Monthly payments on mortgage-related items such as insurance and property taxes.
- Monthly payments on other associated property loans.
- Additional debt obligations of the borrower.
- The monthly debt-to-income ratio resulting from the mortgage.
Define and describe credit risk scoring model types, key variables, and applications
Three model types exist in regard to scoring applications for consumer credit:
- Credit bureau scores: this refers to an applicant’s FI CO score, and is very fast, easy, and cost effective to implement and evaluate. Scores will typically range from a low of 300 to a high of 830, with higher scores associated with lower risk to the lender and lower interest rates for the borrower.
- Pooled model: this model, built by outside parties, is more costly than implementing a credit bureau score model; however, it offers the advantage of flexibility to tailor it to a specific industry.
- Custom model: created by the lender itself using data specifically pulled from the lenders own credit application pool. This model type allows a lender to evaluate applicants for their own specific products.
Every individual with a credit history will have credit files containing the following information:
- Personal (identifying) information which doesn’t factor into scoring models.
- Records of credit inquiries when a file is accessed. Requests for new credit will be visible to credit grantors.
- Data on collections, reported by entities that provide credit or agencies that collect outstanding debts.
- Legal (public) records on bankruptcies, tax liens, and judgments.
- Account and trade line information gathered from receivables information sent to credit bureaus by grantors.
Discuss the measurement and monitoring of a scorecard performance including the use of cumulative accuracy profile (CAP) and the accuracy ratio (AR) techniques
In assessing the performance of the scorecard, a cumulative accuracy profile (CAP) and the accuracy ratio (AR) are often used. The CAP shows the population distribution based on credit scores (and therefore risk) versus the percentage of actual defaults.
Total Return Swaps
While a CDS contract outsources only the credit risk, a total return swap (TRS) outsources both credit risk and market risk. A TRS is designed to mirror the return on an underlying investment, such as a loan, a floating rate note, a coupon bond, a stock, or a basket of assets. There are two parties to a TRS contract. The “payer” is the owner of the underlying asset.
- The payer will agree to pay the underlying asset’s total return, including any price appreciation and coupon or dividend payments, to a “receiver.”
- The receiver is responsible to pay the payer for any depreciation in the asset. The receiver will also pay LIBOR plus a predetermined spread to the payer regardless of what happens with the reference asset.
