Credit risk in a currency swap

The Basel regulators developed a simple formula to calculate the potential credit exposure on an interest-rate swap, which depends on the time-span of the swap and the creditworthiness of the counterparty. They set the credit risk at 1 for every year the swap has to run, and applied the credit weighting on that 1 in the same way as they did for loans, then knocked off 5o in recognition that swap counterparties are usually more creditworthy than most - a rash assumption, as it turned out. So the...

Credit Metrics

The earliest popular model, CreditMetrics is based on historical analysis of transitions from one credit rating to another including the transition to default . It makes several assumptions e that credits within the same rating band have the same risk, although it can vary by business sector e that interest-rate changes have no impact on credit risk e that equity price is a good proxy for asset value e that macroeconomic factors such as unemployment and gdp growth have no impact on credit risk....

Too crude too narrow

This was the snag, as far as the regulators were concerned. Most of the models on the market extrapolate data and observations from the world's best-developed markets, predominantly the American bond and equity markets, and apply them to markets where the parameters may be completely different. For example, default rates and loss recovery from American companies, with the benefit of Chapter 11, are likely to be very different from the aggregate default and loss recovery rate in Japan, Germany...

Offbalancesheet games

Stock and commodity futures had already been traded for almost a century. For some time, banks had provided forward foreign-exchange contracts to help customers hedge payments receivable or payable in other currencies. But apart from the increase in market variables, three phenomena stimulated the growth of complex derivatives. e The increase in computer power. This allowed complex financial calculations involving many variables and many iterations to be done in minutes or seconds. Moore's law,...