Credit Risk and Market Risk - Coursework Example

CREDIT AND MARKET RISKS ………………………….. College ……………………………… ……………….. Words count: 4089 Table of Contents Table of Contents2 Introduction 3 Credit Risk and Market Risk 3 Credit Risk 3 Counterparty Risk 5 Market Risks 5 Relationships between Credit Risk and Market Risk 7 Calculations of Credit Risks 8 Calculation of Market Risk 9 Credit and Market Risks: Reinforcing each other 10 Evolution of Basel Regulations 12 Counterparty Credit Risk and Credit Valuation 13 Counterparty Risk and Valuation in light of Basel iii regulations 14 Conclusion 16 References 17 Introduction The 2008 financial crisis has revealed some significant problems related to assessing and managing financial risks. One important factor that affects these problems is the general understanding about how different financial risks, such as credit risk, market risk and liquidity risk, interact with each others. Banks and other financial institutions attempt to increase their profitability, but it requires an accurate pricing of the risks involved in their assets portfolios. With a view to assess credit and market risks, considerable amounts of researches have attempted to develop frameworks to help measuring or valuing financial instruments that are exposed to credit risks. This paper critically evaluates the credit and market risks and the interactions as well as relations between these two risks. The second part of the paper will explain how each risk reinforces the other to generate large losses. The third section will critically review the contemporary credit risk and credit valuation adjustments in light of the Basel 3 regulations. Credit Risk and Market Risk Credit Risk In financial market, credit risk is the oldest form of risk (Caouette, Altman and Narayanan, 1998). Credit risk is the risk of defaults of reductions in market value caused by changes in the credit quality of issuers or counterparts. It is the risk of changes in value associated with some unexpected changes in the credit quality (Duffie and Singleton, 2012). Credit is the expectation of a sum of money within some limited time, and credit risk is the chance that this expectation will not be met (Caouette, Altman and Narayanan, 1998). In simple wordings, credit refers to borrowings and lending of money. The most common and basic form of credit is ‘loan’ issued to a borrower who may be an individual or a business enterprise. Banks and other financial institutions normally consider only those individuals or firms that show relatively a lower possibility of defaults. In order to evaluate the probability of credit risks associated with defaults, banks and financial institutions usually use several different methods to predict the chances of defaults (Caouette, Altman and Narayanan, 1998). Credit risk consists of two basic components- default risk and spread risk. Default risk occurs when a debtor becomes unable or unwilling to make timely payments of interests or principal amounts. Default risk happens when the debtor defaults on its contractual payment obligation. Credit spread risk is the risk of reductions in market value due to changes in the credit quality of a debtor (Schmid, 2004). As Bielecki and Rutkowski (2002) pointed, default risk refers to the possibility that counterparty in a financial agreement fails to fulfill a contractual commitment to meet his obligation stated in the agreement. Credit risk is associated either with changes in the credit quality or variations of credit spreads or the default events (Caouette, Altman and Narayanan, 1998). Basically, a significant element of credit risk exists even when an individual takes a product or services without making prompt payment for it. In recent years, the credit risk exposures has been increasing in US and most other countries, mainly because of that credit cards issuers also take this risk with all their cardholders (Caouette, Altman and Narayanan, 1998). In line with the emergence of several new kinds of financial transactions, financial institutions have become more aware of credit risk. Financial derivatives such as interest-rate or currency swaps truly represent greater levels of credit as well as market risks (Caouette, Altman and Narayanan, 1998). After the recent financial crisis that started in 2008 and has hit several industries throughout the world, financial institutions and other firms started adopting an effective system of credit risk management. With this management system, firms attempt to maximize their risk-adjusted rate of return by managing a credit risk exposure. After the recent crisis, many firms have been trying to pursue effective techniques such as Global Credit Exposure Information System that was adopted by Bank of America, Citibank etc (Caouette, Altman and Narayanan, 1998). Counterparty Risk Counterparty risk is credit risk that happens between derivatives counterparties. It is a significant factor that has contributed to the financial crisis in 2008. In the contexts of financial risks, counterparty risk is a subset of a single risk type. After the 2008-financial risks, especially due to that some large financial institutions such as Lehman Brothers, Bear Sterns and Freddie Mac have experienced great failures; counterparty risk has become a major concern among financial experts as a key to financial risk. Managing or controlling counterparty risk is critically important because a default of one financial institution would in turn spur many other defaults and generate a downward spiral. Gregory (2011) suggested various techniques such as netting, margining and hedging to mitigate counterparty risks. All these techniques will be helpful to reduce counterparty risks, provided that they may cause an additional operational cost. While counterparts act as intermediaries to reduce the counterparty risks, it is very likely that this will create moral hazard issues and may therefore increase greater levels of systemic risks linked to their failure. Operational risks and liquidity risks will also arise as a result of mitigation of counterparty risks. Market Risks Market risk arises from the changes in financial asset prices. According to Mayo (2007), market risk consists of all those risks that are associated with movements in securities’ prices. Mostly, it is associated with movements in the prices of stock. When a person buys a stock and the market declines, the price of that specific stock will be more likely to fall. Similarly, when there is a hike in the interest rates, it may also cause the stock market as a whole to fall. From the asset management perspective, market risk is very common to all securities of the same class. One important thing to be noted is that the risk cannot be eliminated or avoided by diversifying the stocks (Szylar, 2013). Market risk is termed as systematic risk, because investments will lose money based on the daily fluctuations of the market. Market risks are not diversifiable risks (Ross, Westerfield and Jaffe, 2002) - See diagram outlined above. Out of various stocks, bond market risk, for instance, arises from fluctuations in interests, whereas stock prices are greatly influenced by various factors including company performance, profitability, economic viability, political stability and so on. Corporate organisations have become highly exposed to market risks, because, most corporate enterprises are now exposed to foreign exchange risks as well as community risks due to their interactions in globalized markets. Over the last many years, there has been considerable increase in the size of market risks handled by banks and other financial institutions where as their credit risks have been considerably decreasing in comparison to market risks. Since 1980s, banks have been providing products and services to facilitate the risk management of their customers. In most recent years, banks have adopted systems to manage credit risks actively by transferring them to the capital markets. Banks have also set up measures of arbitrage and proprietary trading books to gain profits from perceived market anomalies (Alexander, 2008). It is critically important for banks to effectively manage market risks. Measuring market risk depends on a number of variables. Financial instrument types, organizational culture of the firm etc are some of such important factors to be taken in to account. There are various methods and techniques that are employed by banks and other financial as well as non-financial institutions to measure the market risks. Value at Risk (VaR) is perhaps, by far, the most widely accepted and effective technique to measure the market risk. The VaR, by its wide use over the last fifteen years has become a well established system and regulatory standard for measuring market risks (Szylar, 2013). Relationships between Credit Risk and Market Risk Most literatures treated credit risk as part of market risks. Duffie and Singleton (20120 stated that credit risk is part of market risk, even though the measurement of credit risk provides its own set of challenges. Most credit sensitive instruments are relatively illiquid. Credit risk is the risk of loss when a counterpart in a transaction defaults on its contractual obligations due to his inability to pay. Credit risk includes a risk arises out of defaults in a loan with a counterpart. Similarly, the risk of default in holding a counterpart’s bond will also be classified as credit risk. But, the risk associated with bond’s price change due to that market’s view of the likelihood of default by counterpart changes, will be classified as a market risk. Credit risks and market risks can be distinguished from one another by identifying credit risk with defaults. Market risk, as detailed above, is described as gains and losses on the value of a position or portfolio that occur because of movements in the market prices, whereas credit risks are gains and losses on a position or portfolio associated with the fulfillment of contractual obligations. In real world examples, movements in market prices are changes in interest rates, exchange rates and equity process, whereas fulfillment of obligations are payment of interests on loans or on bonds, and the reimbursement of the principal amounts of the loan. Market risk and credit risk are basically related to each other. It is argued that they are intrinsically inseparable (Jarrow and Turnbull, 2000). According to this argument, if the market value of a firm’s assets changes unexpectedly, causing a market risk, this would in turn, affect the probability of default by generating a credit risk. In contrast, if the likelihood of default changes unexpectedly, generating credit risks, this would in turn affect the market value of the firm thus causing a market risk. This is how market risk and credit risks are interrelated (Hartmann, 2010). Calculations of Credit Risks Methods used for measuring credit risks differ from one another in their assumptions of measuring and identifying the credit exposure, default probability and recovery rate. There are two basic methods that can be used for measuring the credit risks; first is the method suggested by Bank for International Settlements, labeled as Basel Accord, and the second is a simulation-based approach in which Monte Carle simulation is employed to create profiles of exposures and losses (Aziz and Charupat, 1998) The BIS methodology Banks of International Settlements, due to increased concerns over credit risk exposures, have introduced capital adequacy requirements for financial institutions to deal in derivative securities. This regulation is normally termed as Basel Accord. This requirement suggested that banks must use the specified calculation method to identify the credit exposure to establish a minimum level of capital reserves. According to the Basel methods of calculations, the actual exposure, and the potential as well as total exposure will be defined at the current time. the total exposure of a derivative position which is known as Credit Equivalent Amount will be consisting of two parts, actual as well as potential exposures (Aziz and Charupat, 1998) The Monet-Carlo Simulation for measuring Credit Risks Monet Carlo simulation can be used for estimating credit exposures and losses for derivative portfolios. This method can be used for realistically incorporating the impact of all sources of risks, by setting the correlations between various positions and counterparts, along with netting and mitigating the risks. In Monet-Carlo simulation, a large number of joint scenarios will be generated based on market risk factors that affect portfolio values, credit events such as credit defaults and credit migration, and recovery rates (Aziz and Charupat, 1998). Calculation of Market Risk Value at Risk (VaR) Value at Risk is an extremely useful technique for measuring and calculating the market risk. Value at Risk is a specific amount that the likelihood of experiencing a loss in the market value of a specific financial instrument or a portfolio of instruments in excess of that amount, due to that an adverse change in market risk factors over a specific market risk horizon is less than a specific tolerance level (Schwartz and Smith, 1997). For instance, the chosen risk horizon is two days and the tolerance level is 5%, then the VaR of $2 million for a particular portfolio means that the likelihood of that portfolio that experiences a one-day loss in excess of $ 2 million is less than 5 %. According to this, the expectation will be that the actual daily loss will be exceeding $ 2 million only on two-day horizon out of 40. The flip side of the 5 % tolerance level is a ‘confidence level’ of 95 % meaning that the likelihood of experiencing two-day loss of less than $2 million is 95%. The attractive features of Value at Risk as a risk-metric are many. They are:- Value at Risk corresponds to an amount that could be lost with some chosen probability. Value at Risk measures the risk associated with risk factors as well as the risk factor sensitivities. It can be compared across various markets as well as various exposures. Value at Risk is universally accepted as it applies to all activities and to different types of risks. It can be measured at any different level- ranging from an individual portfolio to a single firm-level VaR measure. When aggregated or disaggregated, the Value at Risk takes account of dependencies between constituent assets and portfolios (Alexander, 2008). Part-2 Credit and Market Risks: Reinforcing each other The 2008- financial crisis has fuelled a complete collapse of the global financial systems and world economy, by severely affecting almost all industries worldwide. As a result, the real GDP in the United States was falling at an average annual rate of nearly seven percent along with drastic drops in domestic and industrial productions. After the crisis, there were many attempts to research the real reasons behind the crisis. Various studies have concentrated on examining the linkage between credit and equity markets in the period surrounding the 2008 crisis. While analyzing the periods immediately before the starting of 2008 crisis, it can be found that the period has witnessed prolonged anomalous behaviour in two markets, credit and housing markets. The 2008 crisis was driven by an extraordinary run-up in the prices of homes in the United States. According to the industry reports, the average home price in the US has been doubled to a record $ 263,000. The home price has witnessed dramatic growth between the periods of 1990 and 2007. The home price has been increased by 9 percent from 1990 to 1995, but by 17 percent from 1995 to 2000 and by a record 6o percent between 2000 and 2007. This rapid increase in the home price has been fueled by the low mortgage interest rates and liberal credit terms. Creative loan terms involved relatively little or no upfront equity, subprime mortgage origination etc (Obi, Ghil and Choi, 2010). Excessive household debts has been another factor the fuelled the crisis. Home mortgage loans grew by more than one trillion US dollars between 1990 and 2007, whereas the outstanding mortgage debts approached $14 trillion. Two unusual market events are identified; the first was that household debt witnessed dramatic growth as twice as fast as personal disposable incomes, and the second was that the rise in stock market values as the credit risk premium continued to increase (Obi, Ghil and Choi, 2010). It was found that the Value at Risk, just before the starting of the 2008 crisis, was relatively mild and was continually declining. It was observed that the Value at Risk initially increased suddenly and almost doubled when the Dow Jones collapsed during November 2008. From the financial turmoil occurred in 2007-2008, it can be understood that financial risks- such as credit risk, market risk and liquidity risks- reinforced one another. It becomes more evident in the case of market risk that is said to include liquidity risk. Due to the fact that credit risk reinforced market risk or market risk reinforced credit risk, it is also important to note that effectively managing one of them can affect the managing of the other too. Market risk that occurs when there are adverse changes in the market prices of a transaction or business has direct impact on the cash inflows as well as cash outflows of a firm. The levels of market risk that produce realized or unrealized gains generate cash whereas those generating losses will absorb cash and require funding. Credit risk is the risk of loss caused by a failure by counterparty to fulfill the contractual obligations. A safe credit risk is one that performs as expected. It will provide the firm with a planned cash flow. However, a poor credit risk is one that either delays or defaults on completing the obligations. This poor credit risk causes cash flow disruption. Even though all firms are virtually exposed to some sorts of credit risks, financial institutions such as those that extend the credit risk through lending, bond underwriting, security trading, security warehousing etc are highly susceptible to credit-risk related problems. A firm that is exposed to credit or market risk is also highly exposed to liquidity risks (Banks, 2013). Evolution of Basel Regulations Basel Committee on Banking Supervision has initially introduced its Capital Accord in 1988 with a view to help financial institutions to take control measures to mitigate losses associated with credit risks. After 1988, the banking sector, including its risk management practices, supervisory approaches and financial marketing characteristics has undergone drastic changes. In order to combat with these changes, Basel Committee released a proposal in 1999 to replace the old Accord with another new and yet more risk-sensitive framework, known as the Basel II Capital Accord. When the committee received several comments from industry and research firms, it released its second consultative document in 2001. Again, the suggestions were criticized and the Committee published revised versions in 2003. In the second round of consultation on capital charge for operational risks, Basel Committee examined individual operational risk loss events, the bank’s quarterly operational risk loss experience and potential exposure tied to specific BLs. After the third and final consultations on operational risk from 2002 to 2003, Basel Committee suggested three methods of calculating operational risk capital charges. These three methods are BIA, Standardized Approach and AMA. These three techniques were developed to encourage banks to develop more sophisticated operational risk measurement systems. The third consultative paper in 2003 amended these provisions by introducing the alternative standardized approach- ASA- that was based on measuring of lending volume rather grow income as indicator of operational risk exposure from commercial banking (Gregoriou, 2009). Part- 3 Counterparty Credit Risk and Credit Valuation The counterparty credit risk is the risk that the counterparty to a transaction defaulted before the final settlement of the transaction’s cash flow (Wei, 2011). The term counterparty credit risk refers to the possibility of non-performance by contract counterparty in any environment involving a contractual relationship. As mentioned earlier, a counterparty risk occurs between derivatives counterparties. When counterparty defaults on a specific transaction due to financial difficulty or going out of the financial agreement completely, it is very likely to arise severe risks to the financial institution. Counterparty credit risk is a more serious issue when there unsecured transactions including interbank transactions. Counterparty credit risk has become a major concern in forward contracting relationships. It is more evident in contracts between dealer banks in the interbank foreign exchange market or between a farmer and a grain elevator in a corn market, for instance. In order to mitigate the counterparty credit risks, Gregory (2011) suggested some measures such as netting, margining and hedging. All these techniques can mitigate the risks associated with credit counterparts, but it may add up some portions of operational costs. Counterparty risk is manifested as a combination of credit risks with other risk types such as market risk, operational risk, liquidity risk and systemic risk. Counterparty risk represents a combination of credit risk with market risk. The interaction between credit and market risks, also in terms that each of them reinforces the other, has been associated with counterparty risk. The management of counterparty risk depends heavily on practices like netting, margining etc to give rise to operational risks. Collateralization of counterparty risks would lead to liquidity risk if the collateral needs to be sold. Central counterparties act as intermediaries so as to centralize counterparty risks that have occurred between market participants (Gregory, 2011). Counterparty Risk and Valuation in light of Basel iii regulations In 2009, The Basel Committee has published a document titled ‘strengthening the resilience of the banking sector’. This document has brought some significant changes to the regulations and capital requirements that were previously established by the Basel Committee’s Capital Accord-ii. These changes to the regulations have been mainly driven by the crisis in 2008. The crisis has highlighted many shortcomings to Basel’s previous regulatory regime. Such as insufficient capital levels, excessive leverage and systemic risks. With a view to overcome these shortcomings, various changes were proposed to improve upon previous regulations (Gregory, 2012). This is how Basel iii came up. The Basel-III regulation has involved a basic requirement for banks to use as a single and consistent stress calibration model to determine the default risks capital charge for counterparty credit risks. portfolio-level capital charge based on effective expected positive exposure or the portfolio-level capital charge based on effective EPE using a stress calibration can be used as base for the above mentioned calculation. The new standard has introduced a capital charge to cover possible market-to-market losses on expected counterparty credit risks (Hong Kong Institute of Bankers, 2013). Basel III regulation has also introduced an asset value correlation multiplier for large financial institutions and it provided a revised calculation method for this multiplier tool. The new regulation has also increased the margin period of risks, by implementing a supervisory floor of five business days to net set of repo-style transactions subject to daily market-to-market valuations. Majority of the changes were relating to the counterparty credit risk. After a considerable period of time for consultation, the final version of the Basel-iii requirements have been published, entitled Basel III: A global regulatory framework for more resilient banks and banking systems. Amendments to the Basel III regulation are summarized as following: Stressed EPE- Expected positive exposure needs to be calculated with parameter calibration based on stressed data. The need for calculating expected positive exposure with parameter calibration has been primarily caused by the pro-cyclical issues of using historical data in which non-volatile markets lead to smaller risk numbers. This, as a result, reduces capital requirements. Back-testing- It is required that validating EPE models need to evolve back-testing to a time period of at least one year. Stress Testing- Another change to the Basel III regulation was related to stress testing. It was about giving an increased focus on the stress testing of counterparty credit risks. Specific wrong-way risk- This change requires that there must be procedure for identifying and dealing with some specific wrong way risks. Increased margin period of risks- Minimum duration for the margin period of risk is an important factor to be considered. According to this change, the minimum period for the margin period of risk need to be increased from 10 days to 20 days. Asset correlation multiplier- A multiplier of 1.25 is suggested to regulated financial firms and to all other exposures to the unregulated financial firms. CVA capital Charge- A capital charge has been introduced to for CVA volatility in addition to the current charges against counterparty credit risks (Gregory, 2012). Conclusion In the aftermath of the 2008 financial crisis, bank regulators devised Basel-III, as a new rulebook that suggests several measures and tools to strengthen the resilience of the banking sectors. Banks and other financial institutions are primarily required to manage various risks, such as credit risk, market risk, liquidity risks etc, and for this purpose, major upfront efforts have been put in to designing and developing new capital requirements that would provide banks and financial firms with sufficient reserves to withstand future risks and crisis. This paper highlighted that credit and market risks interact with each others, and they together contribute to financial crisis if not managed adequately. Credit risk occurs when market value declines due to changes in the credit quality of issuers or counterparts. Market risk occurs when financial assets price change over time. Both these risks reinforce the other and this has been evident from the empirical studies about the 2008-crisis. This paper has critically evaluated these risks and counterparty credit risks in light of Basel III regulations. References Alexander, C, 2008, Market Risk Analysis, Quantitative Methods in Finance, John Wiley and Son Aziz, J and Charupat, N, 1998, Calculating Credit Exposure and Credit Loss: A Case Study, Algo research quarterly Banks, E, 2013, Liquidity Risk: Managing Funding and Asset Risk, Palgrave Macmillan Bielecki, T. R and Rutkowski, M, 2002, Credit Risk: Modeling, Valuation and Hedging, Springer Science & Business Media Caouette, J.B, Altman, E. I and Narayanan, P, 1998, Managing Credit Risk: The Next Great Financial Challenge, John Wiley & Sons Duffie, D and Singleton, K.J., 2012, Credit Risk: Pricing, Measurement, and Management, Princeton University Press Gregoriou, G. N, 2009, Operational Risk Toward Basel III: Best Practices and Issues in Modeling, Management, and Regulation, John Wiley and Son Gregory, J, 2011, Counterparty Credit Risk: The new challenge for global financial markets, John Wile and Sons Hartmann, P, 2010, Interaction of market and credit risk, Journal of Banking & Finance 34, 697–702, Elsevier Hong Kong Institute of Bankers, 2013, Operational Risk Management, John Wiley and Son Jarrow, R and Turnbull, S., 2000, The intersection of market and credit risk, Journal of Banking and Finance Mayo, H. B, 2007, Basic Finance: An Introduction to Financial Institutions, Investments, and Management, Thomson South-Western Ross, S.A, Westerfield, R.W and Jaffe, J., 2002, Corporate Finance, McGraw Hill Irwin Schmid, B, 2004, Credit Risk Pricing Models: Theory and Practice, Springer Science & Business Media Schwartz, R. J and Smith, C.W., 1997, Derivatives Handbook: Risk Management and Control, John Wiley & Sons Szylar, C, 2013, Handbook of Market Risk, John Wile and Son Wei, W, 2011, Counterparty Credit Risk on a Standard Swap in “Risky Closeout”, International Journal of Financial Research Read More