Market and Credit Risks Measurements - Report Example

Credit and Market Risks 2/28/2010 Student Aims and objectives of the paper Part 1 covers the developments in the credit and market risks. While doing so, the essay provides the measurement and management methods in relation to the current financial crisis. In the end, it summaries the available methods while giving their strengths, weaknesses. It also gives the mechanism of the implementation in effective risk management policy. Part 2 discusses the credit risk and thoroughly examines its management in the current financial markets based upon the modern methods of credit risk exposure, risk factors, its pricing and incorporation in the instruments and making the credit markets viable and feasible. Part 1 Discussion on the developments in the Market and Credit Risks Measurements and management in view of the Financial Crisis Generally, there are following types of risks in the financial markets. Market risks Credit risks Liquidity risks Operational risks Systematic risk Price or rates risks Credit quality volatility Unadjusted financial positions Fraud and systems failures , legal and regulatory risks Market ruptures breakdowns Risks in the financial markets are many and multiple. In the background of current world financial crunch and crumbling financial institutions in the United States of America and Middle East countries like Dubai, the markets and credit risks have become more prominent and imminent. So, there is a need to understand the difference between the two terms and have an in-depth knowledge of their measurement and management. Market risk is the genre term of any sort of risk associated with the nature, quantum, working and outcomes of a market, whereas the credit risk refers to that signified element of risk which is hidden in a derivative transaction (Chand Sooran 2007). The important methodological distinctions of liquidity and time horizons make the two things different from each other. If price volatility defines the market risk then default defines the credit risk. A market price risk is conceptually the negative daily profitability of a firm. The relative market prices of other firms and products are also included in the market price risks (Joetta 2005).The performance hedges automatically change negatively. On the other hand, credit risk directly involves the default or the short credit supply by the creditor to the counterparty. The negative impact of the credit risk is the high price of credit for the other borrowers and volatility of credit from the market etc. The dealers in the financial markets are always very cautious about their dealings with their counterparts in their swap transactions. It simply means that greater charges are levied on the financial transactions by the dealers against their counterparties (Andrew Fight 2006). The greatest risk envisioned by the dealers can be the risk of default in repayment of installments by the counterparty. The market fluctuations and untoward changes often put the portfolios of the counterparties at the default position. In this way the credit-worthiness of the counterparties also adversely suffers. The market and credit risks have become more obvious after the emergence of regulatory regimes like insurance companies etc. The common revaluation method is the market risk management system (Heath, Harrow, and Morton 1992). Available Methods, their strengths and weaknesses Option for large portfolios and loans positions can be obtained by the integrated pricing and management system. The components of the market risks are developed. Risk factors driving portfolios returns are priced and managed. The market risks are visualized and calculated on the basis of abrupt price fluctuations in the markets. Delta gamma approach sees at the stochastic volatility of equilibrium in the markets. The tail losses of the portfolios are measured on the basis of their exposures in the markets (Tomlinson, Richard; Evans, David (2007). The alternative conceptual, critical assessment approach in vogue in the markets is given as below. Its strengths and weaknesses of the contemporary practices are as well given. The modeling is done by the portfolio risk measurement. Pricing is done for credit derivatives, financial collaterals and bonds and securities. This model is meant for the OTC (Over-the-Counter), bank loans, leases, investment portfolios, and the supply agreements. Pricing for the credit risks in trading and product marketing is also focused in this approach. In this way, the pricing and risk measurement is done by the alternative conceptual approach (Credit Risk Management, L.L.C). Generally, the approach considers the viability and yieldable financial outcomes of a diverse portfolio of a firm with a holistic consideration of its instruments and does not essentially take into account only the one aspect of market failures of the portfolios. Therefore, there is a definite reason to believe that credit risks are different from the market risks. There can be two major credit risks that can not be attributed to the market risks. These two reasons are moral hazard and adverse selection of the counterparty. This aspect of credit risk limits the counterparty by region, education and moral soundness in many ways and segregates the counterparty from the general market risks. Generally the credit risk measurement is not done by the credit officers including the above aspects of the credit-worthiness of the counterparties and the approvals or disapprovals are done arbitrarily on the basis of general credit risks. The credit exposures must include all the symmetrical pricing for the risks involved. The credit risks can also not be calculated on the daily or weekly basis but this measurement is always a longer term basis. Particularly the foreign exchange products cannot be evaluated on the criteria of risk measurement on short term basis. The Euros and Dollars are daily changing their positions viz-a-viz local currencies. Similar is the situation of gold in the global market. Hence the bonds, securities, saving certificates, bank loans, bank leases, and bank guarantees in foreign exchange are imprudent to be evaluated on short term basis. This is what is being done presently in the market and credit risk practices, which are entirely, wrong (Defaultrisk.com). Therefore, in order to fully capture the concepts of the market and credit risks it is imperative to understand the economic principles of the risk management. The risk management for the financial institutions covers the markets, credit, and operational risks with good managerial practices (www.netadvantage.standardandpoors.com). The default and transition risk coverage in the single issuer scheme, and the credit risk evaluation has to be understood. The correlation of default and portfolio valuation has to be studied in detail. Credit risk pricing for the OTC derivatives has also to be fully understood. The details are described as under. Risk Measurement Risk Exposure In order to have a fair idea of the measurement of the market and credit risks the measurement, accurate estimation and predictability of extent and the sources of such risk exposures is necessary. The sources of exposure to risk can be as many as described earlier, like market failures, operational, geographic , legal, religious, disasters , frauds etc. the sources of risk exposure can be more or less easily defined. But their accurate estimation and forecast is subject many factors. Changing positions of the cost of the capital involved is another significant factor that can easily venture into this situation. For instance the forecasts for the foreign currencies , gold, oil and food items as collaterals or the capital goods is always very unpredictable in the current fluid situation of the world market. Again climatic changes, disasters and terrorism have become another bigger risk factor, both for the markets and the credits. The risk exposure also mainly depends upon the daily exchange markets where prices of the shares of the major cartels and corporations go up and down without much predictability. Therefore, the scarce risk capital can not be confidently allocated without market and credit risks. The financial integrity of the firms can be reported by the outside reporting agencies and authorities, that may not be essentially owned or refuted by the firms themselves. However, the government plans and policies can be having a mitigating factor on the risk exposure of markets and credits for different firms, counterparties, lenders and financial products like bonds, guarantees, loans, agreements. Leases and supplies etc (Chand Sooran (2007). the risk exposure depends upon all the above factors and is basically contingent upon all the above matters. Economic cost of risk assessments While making calculations for the financial costs of the risk exposures and risk estimations, it is always advisable to aggregate all the desks and all the products exposed to risks. This approach is prudent and feasible coastwise. However, It is always not very easy to accurately measure the probability and chances of a default (Dr Risk. Forward Delta (11/7/00). The negative credit event occurs when a default is there. Usually the historical information is gathered and analyzed for the particular class of credit like bank leases or loans for a particular product. In the corporate bond market the credit spreads are also observed. For this purpose www.riskmetrics.com is also used. The recovery rate is also difficult to accurately measure. For instance if Mr. A buys a bankrupt firm of US $ 10 million for 2 million dollars, the recovery rate can be 20% for a bank from Mr. A that had advanced the credit to the firm in the first instance. Hence there are two steps involved in the process of risk calculations. First is the credit exposure estimation and the second is the calculation of default probability. Credit exposure is in fact, the situation of counterparty within the ambit of all the other credits from other parties, organizations and institutions. This aspect also considers the life span of the other credits and their repayment mode and behavior. Value at risk technique is used for this purpose. The negative value for this measurement obliges the creditor for payment. Default Intensity The process of default intensity has to be tracked down through an elaborate and exact model. Knowledge about the default intensity is the outcome of this model that has been described above. It investigates the circumstances under which the counterpart will default over a short interval of time in future and estimates the likelihood of such a default. For this purpose the model banks upon the information from all reliable sources and manipulates the information and data thus gathered. The historical reviews of the credit defaults for various products, parties and regions are done for the convenience of research and study (Joetta 2005). Then the default model is thus calibrated. Thus the credit ratings for the counterparty are calculated for up gradation or down gradation. Tractable algorithm computational model tells about all the above-said default intensity and credit rating of a counterpart based upon well estimated credit and market risks. Hence this alternative approach model has outpaced all the other models and approaches in the market and credit risks. This approach is holistic, trustable and more confident than other approaches. It is beneficial both for the borrowers and lenders, at the same time it suits the needs of all the parties involved in a contract or agreement. Particularly the third parties who stand surety can feel more secure by this approach. Hence the final pricing of defaulting financial instrument is done through the use of above said functional models. Overview of the Alternate Conceptual Approach Model Default risk is always present and the securities have to be prices and assessed against the presence of this default risk. The basic instrument of zero defaulting coupon bonds is made as an example in this model. Then while comparing and contrasting it with the aspects of alternative approach model. The reduced form is taken as external to the mitigation of default risk alongside the current and historical default data. The structural aspects put the onus on the insurer to bear all the costs of risk of the default. Assets and liabilities are put across each other. Since most of the other approaches take one or the other aspect of the above two mentioned aspects, but the alternate model take both of them together. Mapping of historical default probabilities is also taken as a part of this approach. It means that the breakthrough has been done based on the earlier works of the economists. They had already computed the risks for investors, cash flows, the equity options etc. Then the most important aspect of the recovery from default is also taken into consideration in this model. This is perhaps the most important and most significant part of this model which is not available in other approaches that are in vogue in the contemporary theoretical models of the markets and credit risks. Here the pricing of the corporate bonds is done in more details. The terms and conditions of the transactions under which these bonds are issued and used are renegotiable and the value for money is reassessed under this alternate approach model. The defaulting instruments have their own peculiar circumstances and the conditions; therefore even the courts do consider the bankruptcy cases in very different and customized way. Therefore, the alternate model takes care of all the circumstances under which a default occurs and also takes care of the recovery process of the losses in the event of default. The credit ratings provided by the Standards and Poor’s or Moody’s , the internationally famous credit rating agencies can be very well depended upon as has also been recommended in this alternate conceptual model of market and credit risk assessments. The discrete indicator of credit rating of counterparty can give a fair and almost reliable idea of the credit risk. In this regard the credit risk cannot be read in isolation from the market risks. Hence a thorough and comprehensive approach exists in the alternate model of conceptual approach. Benchmarking for the swaps and sovereign bonds is also done on the basis of the structural changes on the basis of the overall global or a country specific political policies shift in the favor of or against a particular product or instrument. For instance the credit worthiness of the Russian bonds at the end of 1998 and the Iraqi bonds at the end of 2008 have been discussed in this elaborate but specific model. The credit swaps in the derivative markets of the contemporary world are widely taken care of in this model. It is observed that the credit swaps are happening in the credit markets for the cash flows. The insurance cover to various financial risks and reinsurance of the insurance companies is the best available example inn this connection. The pricing models of this approach look deeply and thoroughly on the very structures of these financial transactions, instruments and deals (Tomlinson, Richard; Evans, David 2007). The yield spreads; it is believed that they do cover the security risks. At this point both the exchange rates and interest rates are considered and accounted for the pricing purpose. Default correlations account for the risk bearing costs of the multiple or single issuers of the treasury notes or bigger transactions of corporate deals in leases and loans etc. CDO, being the collateral debt obligation is given the full and secure attention in security of credit risks for the loans; bonds etc. Similarly the concept of collateral mortgage obligation is also involved in the new alternate model. Therefore all the complex instruments are very well analyzed in this new approach. Since credit risk has two sides. In the case of default the creditor goes into a loss. In case of market failure the counterparty goes into loss. Therefore, mid market pricing system is needed to adjust the default of both or on the either side. Risk Management System and its implementation Credit exposure calculation involves several complicated factors (Chand Sooran 2007), these factors including credit enhancement techniques are given as below. 1- Forecast for the default probability is always limited by the estimation for credit risks. 2- The longer life of the credit contracts attracts more defaults. 3- Cash flows reduce the credit risks over time. 4- Amortized payments recover the credit risks in the first installments. 5- Settlement risks involve early payment penalties. 6- Current positions of counterparties don’t predict the future risks or otherwise. 7- Credit risks have brought the legal practitioners on side of the lenders and financial institutions against counterparties. 8- Netting techniques are being used by the banks and borrowers both to mitigate the credit risks. 9- The maximum collaterals are kept surety in the borrowers’ chests by the counterparties. 10- Third party guarantees are also being taken by the banks and financial institutions. Part 2 I have taken up the credit risk for further discussion of the two topics. Because I think credit risk is the outcome of market risk also. I want to further specialize in this topic and attended the presentations, workshops and seminars on the topic. I have learnt all the basic principles on the basis of which the credit risk is estimated, its factors are identified, how the credit risk is priced and incorporated in the instruments and the financial transaction (Joetta 2005). The risk coverage scheme of the credit risk has been understood by me in more details and same is presented below in the form of management techniques and methods of the credit risk management. Credit risk covering system includes the appraisal of the counterparty’s portfolio. All possible means and methods are employed to assess the credibility, goodwill, reputation and credit worthiness of the counterparty. For this purpose the moral and legal record of the counterparty and his past repayment behavior is also taken into account (http://www.ebsglobal.net/programmes/credit-risk-management). The first method for credit risk management is to examine the application form and all the documents provided by the counterparty. All other loans, leases and credit card transactions of the counterparty are taken into account. A firmed up and mutually agreed repayment plan is arrived at by the two parities (Andrew Fight 2006). Then if the position of the counterpart comes out clearly then the collaterals of the counter party are reassessed. The bank loans and credit cards have become very common in the market at mass and retail level. In this manner if the need is felt the legal documents are also got vetted by the legal advisors of the lending parties and the counterparties are bound to obey and in case of default the counterparties are made to repay. The early repayment schedules call for the inbuilt penalty plans in order to ensure the credit risk and its operational and processing costs (Amanda 1998). Now a new and compulsory system of risk insurance has been introduced by the lending parties and the cost of this risk coverage is also being paid by the counterparties. This system is insurance on the loans for goods, leases and mortgages. The insurance companies are being reinsured by the reinsurance companies. All the risk coverage and costs related with the assessment and application costs are being incorporated in the products and derivatives over the counter (Heath, Harrow, and Morton 1992). . However, good risk management technique lies in the new and alternative conceptual model, where the pricing for the risks involved are done in the elaborate, shared, and equitable manner. This is concluded that if the pricing for the credit risks is not proper and accurate then the credit markets are either skewed or distorted. It is therefore, recommended that estimations for the credits risk must be as much fair and accurate as possible. The default probability should be fairly and accurately measured. If all the above techniques are fairly employed then the credits can be feasibly availed by more number of counterparties and more confident and vibrant credits markets can come to play between the parties (http://www.sas.com/reg/gen/corp/798169). The economies can prosper and the trickle down effect can spread over larger proportions f population in the world. It is therefore, summed up that the credit risk can be alleviated by the fair and elaborates techniques of risk estimation and risk management. Conclusion In the conclusion, it can be said that the new financial markets are very trendy but also very risk. The lending, borrowing, the leasing, swapping, mortgaging, and sale purchase of instruments and derivatives is a witty but a risky process. There are various involved in the markets. The market risks and credit risk are inclusive to each other, yet different from each other too. The credit risks can be gauged from the credit rating but this phenomenon is also contingent upon many other factors. The conventional approaches have been looking at one aspect of counterparties with respect to heir credit worthiness, whereas the new approach called alternate conceptual model attends to all the possible aspects of risk exposure and ties to thoroughly estimate them. The default intensity of the borrowers can be measured from the credit repayment history, the present circumstances of the borrower and the other conditions that are likely to occur within a short span of time. The alternate approach is very all encompassing and holistic in nature. All the previous approaches are taken care of in this new approach. This approach is very strong because of the features discussed in the above paragraphs. The estimations are near accurate; the models for recovery of losses from the default on either side of the parties are also catered for in this approach. The profounder of this approach have proudly taken care of the risk exposures, the financial cost in estimating the risk exposure and risk factors. The integrated approach in the market and credit risks is thoroughly given in this new model. Hence, there can be no better option for a risk manager than to adopt this approach for a practical and thorough solution of the risk problems in the money and financial markets of the world today. Reference 1- Chand Sooran (2007), Principal Victory Risk Management Consulting, Inc 2- Forward Delta (11/7/00) The William Margrabe Group, Inc.  3- Dorfman, Mark S. (1997). Introduction to Risk Management and Insurance Prentice Hall ISBN 0-13-752106-5 4- Amanda 1998 Principles for the Management of Credit Risk 1999http://www.bis.org/publ/bcbs54.htm 5-The Risk Management Association; leading industry organization for credit risk professionals 6-Defaultrisk.com - web site maintained by Greg Guyton with research and white papers on credit risk modeling. 7-Credit Risk Management, L.L.C. Raleigh, NC  27612 8-Best practices in reporting at http://www.sas.com/reg/gen/corp/798169 9- http://www.ebsglobal.net/programmes/credit-risk-management 10-   Joetta 2005. Credit Risk Management: How to Avoid Lending Disasters and Maximize Earnings 11- Andrew Fight 2006. Credit risk management ISBN 56478432 12-Tomlinson, Richard; Evans, David (2007) "CDOs mask huge sub prime losses, abetted by credit rating agencies" International Herald Tribune 13-Heath, Harrow, and Morton (1992) Market risk coverage. ISBN @56786543 14www.netadvantage.standardandpoors.com/NASApp/NetAdvantage/servlet/login?url=/NASApp/NetAdvant 15- www.riskmetrics.com Read More