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Introduction

Credit Risk is the risk of loss to an organization if one of its trading counterparties should default. In the event of a default the loss is measured as the positive value (mark to market) of the outstanding trades with the counterparty. If the value is negative then there is no loss (and no gain either as creditors for the defaulting counterparty will still demand settlement of the trades).

The measurement of credit risk goes beyond the potential loss today to look at the possible worst case outcome over the life of the portfolio of trades with the counterparty. So, the logic goes, if rates move favourably for an organisation the value of trades it holds with a counterparty will rise so the credit risk to that counterparty will also rise. Vector Risk can measure the expected loss (average positive mark to market across all future scenarios) and unexpected loss (worst case loss to a prescribed confidence interval; eg 95%).



Credit Risk Measures

Current Exposure (CE)

• The portfolio of trades with a counterparty is marked-to-market with current rates and the amount owed by the counterparty in the case of immediate default is determined.
• Current exposure is measured as a by product of PCE or CVA calculations.

Expected Exposure (EE)

• For non-exchange based products, market price scenarios are generated into the future and the portfolio of trades for a counterparty is tracked over those paths until the last trade matures.
• The value reported is the sum of positive exposures at each time step divided by the number of scenarios.
• Used to represent expected losses in the event of default of the counterparty

Credit Valuation Adjustment (CVA)

• This is a market-based price for the expected loss from trades with a counterparty incorporating the expected credit exposure (loss given default) over time and the probability of default of the counterparty.
• Estimates for these quantities are derived from market variables such as credit spreads and arbitrage-free interest rate models.
• The Vector Risk service also calculates related statistics DVA (debit valuation adjustment) and FVA (funding valuation adjustment).
• Curve evolution uses "risk neutral" assumptions.

Potential Credit Exposure (PCE)

• For non-exchange based products, market price scenarios are generated into the future and the portfolio of trades for a counterparty is tracked over those paths until the last trade matures.
• The highest amount owed by the counterparty to some confidence interval is reported.
• Used to represent extreme losses in the event of counterparty default.
• For exchange-traded products where margin calls are made, a simpler value-at-risk method is used with a short, fixed time horizon to determine likely margin calls.
• Curve evolution uses "real world" assumptions.

Effective Expected Potential Exposure (EEPE)

• Effective EPE has been chosen by Bank regulators as a common basis for capital calculations to be reported by all banks.
• The calculation is based on expected exposure with some arbitrary adjustments as follows:
• Starting with the definition of expected exposure (EE) above,  EPE is the average EE over the first year of exposure. Effective EE is an arbitrary adjustment to EE that finds the maximum EE in the first year and assumes EE stays at this level for the remainder of the year. Effective EPE is the average of Effective EE. This value has been chosen by Bank regulators as a common basis for capital calculations to be reported by all banks.            

Margining

• New regulations (eg Dodd-Frank in the US) require banks and other financial institutions to trade many derivatives through exchanges instead of directly with other banks.
• A market risk (VaR) style measure of the potential loss (to a given confidence) for one day on a portfolio.
• Includes netting and natural (economic) offsets between trades.