Value at Risk for Unsecured Fixed Income Derivatives

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Helsinki University of Technology | Diplomityö
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Date

2006

Department

Tuotantotalouden osasto

Major/Subject

Yritysstrategia ja kansainvälinen liiketoiminta

Mcode

TU-91

Degree programme

Language

en

Pages

82+7

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Abstract

The increased use of fixed income derivatives and the growth in the over-the-counter (OTC) fixed income derivatives market has made efficient and effective management of market and counterparty credit risk important for market participants. In contrast to exchange traded derivatives, OTC derivatives have no guarantees of the counterparty of a derivative being able to meet its contractually defined obligations. OTC traded fixed income derivatives are hence subject to both market risk, due to fluctuating interest rates, and counterparty credit risk, due to the risk of the counterparty of a contract not being able to fulfill its obligations. These risks can be quantified using the value at risk (VaR) metric that summarizes the risk exposure by answering the question "What is the maximum amount of money that can be lost on a portfolio over a given period of time, with a given level of confidence?" This study provides an overview of the available modeling techniques used to calculate VaR for market and credit risk, along with their respective strengths and shortcomings. The potential benefits and problems associated with integrated management of market and credit risk are reviewed. The requirements for modeling techniques used in integrated frameworks and proposed solutions for integrated risk management are also examined. A simulation framework for integrated management of market and credit risk is presented and tested for a portfolio of interest rate swaps. The model's sensitivity to various input parameters is evaluated to identify the key drivers of overall risk in the simulated portfolio. The impact of portfolio modifications is also examined. A key conclusion from the simulation results is that interest rate volatility highly affects the overall risk of a portfolio that is well-hedged against market risk due to increased counterparty credit risk exposure. The results also show that the retained counterparty credit risk for a financial intermediary can be significant in such settings, highlighting the need for financial intermediaries to use credit derivatives to transfer counterparty credit risk to natural bearers of credit risk.

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Supervisor

Maula, Markku

Thesis advisor

Stokke, Svein

Keywords

value at risk, fixed income derivatives, market risk, credit risk, integrated risk management

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https://urn.fi/URN:NBN:fi:aalto-2020120552554

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[dipl] Teknillinen korkeakoulu / TKK