when a counterparty is unable or unwilling to meet agreed obligations. .. 5 Modeling counterparty credit exposure for credit default swaps, Christian t. hille, john Figure 4: PFE and EE profiles through the life of the contract in relation to the. time significantly without loosing generality in exposure profiles. Antithetic . Price distributions of an interest rate cap, floor and swap. . It is a telephone- and computer-linked network of dealers, who do not physically meet. Trades. Implementation of Swap-Settled-Swaptions. to assess the counterparty's ability to meet its obligations. It is crucial for a Before calculating exposure profiles, however, it is crucial to understand the subject of credit. ∗.
However if the contract has negative value for the counterparty that does not default, this counterparty does not get to walk away from the contract in the event that their counterparty defaults. For this reason, the replacement cost is the greater of the fair market value of the contract and zero. This is known as current credit exposure. While this is a useful and commonly used metric of credit exposure, it only provides a snapshot of the exposure at a single point in time.
The value of derivative contracts can fluctuate significantly over time, therefore it is also very useful to consider the credit exposure at future times.
This is known as potential credit exposure. Only the current exposure is known with certainty, while the future potential exposure is uncertain.
P2.T6.413. Credit exposure profiles
Potential credit exposure is an estimate of the replacement cost of the contract at various times in the future. Commonly, a time horizon of six months to a year is used, with contract values calculated at various times over the time horizon. In FINCAD Analytics Suitea 1-factor short rate model implemented on a trinomial tree is used in order to estimate the range of possible future values for a portfolio of interest rate swaps, each of which can be non-amortizing or amortizing.
The swaps are with the same counterparty, and netting agreements can be taken into account see below.
P2.T Credit exposure profiles | Bionic Turtle
If there is only one swap with the counterparty, then the same functionality can be used by setting up a portfolio containing just a single swap. Based on the trinomial interest rate tree, a probability distribution is calculated at future time points, from which the expected level of credit exposure that is unlikely to be exceeded at a given confidence level is calculated.
For example, we can calculate the distribution of portfolio values one year from present and take the 95th percentile of this distribution.
Netting agreements are risk mitigants built into the derivative contract, where in the event of default the marked-to-market values of all the derivative positions between the two parties that have netting agreements in place are aggregated, i. Therefore only the net positive value represents the credit exposure at the time of default. Assuming that netting agreements are in place, the Potential Future Exposure is Having netting agreements in place reduces the overall credit exposure for the portfolio.
In cases where there are no netting agreements, portfolio credit exposure can be calculated by summing the exposures of the individual swaps in the portfolio.
The curve PE t is the peak exposure profile up to the final maturity of the portfolio. For each interest rate swap in our portfolio we would need to: Identify points of interest settlement dates or legs.
At each point estimate worst case market shocks for a given confidence level include both normal and stressed conditions. Mark to market the transaction at point of interests. Plot positive MTM exposure at points of interest.
Potential Future Exposure – PFE – Calculations for an Interest Rate Swap.
The drivers — Forward Rates — Current and implied forward rates The value of our swap is driven by current and implied future interest rates. To understand how to bootstrap implied forward rates from a yield curve please see the step by step calculation guide in the implied forward rate case study. The case study describes how to boot strap rates and use them for marking to market interest rate swaps. For the purpose of our PFE case study we use the following yield curve and implied rates.
For a detailed review of multiple interest rate simulation approaches please see the interest rate simulation crash course. We first estimate the value of the swap for both counterparties, the customer and the bank at time zero.
To keep our calculations simple we ignore the impact of discounting time value of money in our valuation model and just do a simple addition of cash flows for both the fixed rate receiver and the floating rate receiver.
Also note that this set of calculations is done using the original yield curve and implied forward rates at time zero and does not include the impact of changes in interest rates, yield curves or implied forward rates. The change happens because the first leg highlighted has been settled and is no longer included in future cash flows. We now repeat this process for the life of the transaction or the next four legs.
Within the table below you can see both sides of the transaction. The counterparty which is us as well as the bank the seller of the swap.
IRS PFE Results — First path only For the rates used and the swap structure in question, it appears that after the first leg, it will be the counterparty that will be exposed to the bank, rather than the other way around.