THE CREDIT RISK OF COMPLEX DERIVATIVES

Transcription

1 THE CREDIT RISK OF COMPLEX DERIVATIVES

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3 The Credit Risk of Complex Derivatives Third Edition ERIK BANKS

4 Erik Banks 2004 All rights reserved. No reproduction, copy or transmission of this publication may be made without written permission. No paragraph of this publication may be reproduced, copied or transmitted save with written permission or in accordance with the provisions of the Copyright, Designs and Patents Act 1988, or under the terms of any licence permitting limited copying issued by the Copyright Licensing Agency, 90 Tottenham Court Road, London W1T 4LP. Any person who does any unauthorised act in relation to this publication may be liable to criminal prosecution and civil claims for damages. The author has asserted his right to be identified as the author of this work in accordance with the Copyright, Designs and Patents Act First published 2004 by PALGRAVE MACMILLAN Houndmills, Basingstoke, Hampshire RG21 6XS and 175 Fifth Avenue, New York, N.Y Companies and representatives throughout the world PALGRAVE MACMILLAN is the global academic imprint of the Palgrave Macmillan division of St. Martin s Press, LLC and of Palgrave Macmillan Ltd. Macmillan is a registered trademark in the United States, United Kingdom and other countries. Palgrave is a registered trademark in the European Union and other countries. ISBN ISBN (ebook) DOI / This book is printed on paper suitable for recycling and made from fully managed and sustained forest sources. A catalogue record for this book is available from the British Library. A catalog record for this book is available from the Library of Congress. Editing and origination by Curran Publishing Services, Norwich

5 To my wife, Milena

6

7 Contents List of Figures List of Tables Preface x xiv xvi PART I DERIVATIVES, CREDIT, AND RISK MANAGEMENT 1 An Overview of the Derivatives Marketplace 3 Derivatives Market Scope 4 Market Volatility and the Growth of Derivatives 10 General Derivative Risk and Return Considerations 15 Addressing Derivative Risk Management Issues 19 Overview of the Text 25 2 Derivative Losses 27 Sources of Derivative Losses 27 A Sampling of Derivative Losses 30 3 Risk Governance and Risk Management 42 Corporate and Risk Governance 42 Credit Risk Management Processes 43 4 Regulatory and Industry Initiatives 54 Regulatory Efforts 54 Industry Efforts 68 vii

8 viii CONTENTS Part II THE CREDIT RISK OF COMPLEX DERIVATIVES 5 Classification and Quantification of Credit Risk 81 Background 81 Market Risk 82 Risk Equivalency 86 Risk Factors 88 The Risk Equivalency Framework 98 Refining Risk Equivalent Exposure 101 Simulation: An Alternative Methodology Quantifying Option Credit Risk 108 An Overview of Option Credit Risk The Credit Risk of Compound Option Strategies 121 Product Description 122 Credit Risk Quantification The Credit Risk of Complex Options 160 Product Description 164 Credit Risk Quantification Quantifying Swap Credit Risk 241 Actual Exposure of Swap Contracts 242 Fractional Exposure of Swap Contracts 246 Swap Credit Risk in a Complete Framework 248 A Model for Calculating Swap Credit Risk 250 Empirical Findings on Swap Risk Factors The Credit Risk of Complex Swaps 260 Product Description 261 Credit Risk Quantification 288 Part III CREDIT PORTFOLIO RISK MANAGEMENT ISSUES 11 Credit Risk Management of Derivative Portfolios: Quantitative Issues 321 Consolidating Individual Credit Exposures into Portfolios 322 Portfolios of Counterparties 341 Quantifying Credit Losses Credit Risk Portfolio Models 367 Value-at-Risk and Regulatory Models 367

9 CONTENTS ix The Ideal Generic Credit Portfolio Model 369 An Overview of Specific Credit Risk Portfolio Models Credit Risk Management of Derivative Portfolios: Qualitative Issues 385 Managing Derivative Credit Exposures Dynamically 385 Addressing Ancillary Credit Risk Management Issues 412 Appendix 1: Option Valuation 420 Appendix 2: Twenty Questions for the Derivatives Desk 428 Appendix 3: ISDA 2002 Master Agreement 430 Notes 467 Glossary 494 Bibliography 541 Index 549

10 List of Figures 1.1 General classification of derivatives General classification of swaps General classification of options Derivative asset classes Eurodollars (US$ Libor), 15-year average volatility (%), Year US Treasury bond, 15-year average volatility, S&P500 index, 15-year average volatility, Crude oil (light sweet crude), 15-year average volatility, Gold, 15-year average volatility, US$/Japanese yen, 15-year average volatility, US$/Pound Sterling, 15-year average volatility, Notional outstandings, OTC derivative contracts, Gross replacement cost, OTC derivative contracts, Risk-adjusted returns Common credit risk mitigation techniques Board level credit risk management duties Corporate risk management duties Sources of credit risk in a financial institution Credit risk governance process Forms of regulatory and economic capital BIS IRB approaches 65 x

11 FIGURES xi 5.1 Normal distribution Lognormal distribution Path of the risk factor at 10% volatility, 97.5% confidence level Path of the risk factor at 10% volatility, varying confidence levels (90 99%) Path of the risk factor at 97.5% confidence level, varying volatilities (10 30%) The risk equivalency process Alternative risk exposure paths Sample asset price paths Long call payoff profile Long put payoff profile Short call payoff profile Short put payoff profile Bullish vertical call spread payoff profile Bearish vertical put spread payoff profile Long straddle payoff profile Short straddle payoff profile Long strangle payoff profile Short strangle payoff profile Long butterfly payoff profile Short butterfly payoff profile Long condor payoff profile Short condor payoff profile Call backspread payoff profile Call ratio vertical spread payoff profile Synthetic long payoff profile Synthetic short payoff profile Bullish vertical call spread with a single counterparty Bullish vertical call spread with multiple counterparties Up and out call option Down and in put option Average price put option Average strike put option Floating strike lookback call option Put option on the minimum High low option Partial lookback call option Ladder call option Cliquet put option 177

12 xii FIGURES 8.11 Shout put option Installment call option Cash-or-nothing at hit put option Option on the best of two assets and cash Put option on the worst of two assets Multiple strike call option Spread call option Basket call option Compound call option Regular chooser option Contingent premium call option Deferred payment American call option Quanto option on put structure Exploding call option Squared power call option The simulation approach to credit risk valuation Swap replacement cost curve Inverse floater swap Pay/receive flows of leveraged swaps Leveraged swap Leveraged inverse floater swap Differential swap Creation of a US$ Libor/Euribor differential swap Amortizing swap Mortgage swap Index principal swap Reverse index principal swap Credit forward Default swap Total return swap Equity call swap Equity call put swap Realized volatility swap Zero coupon inflation swap Peak electricity swap Cooling degree day swap Decomposing a leveraged inverse floater swap Credit transaction decision process Maximum peak and forward point exposures Forward point exposures 1 337

13 FIGURES xiii 11.4 Forward point exposures Derivation of possible credit losses REE probability distribution Default rate probability distribution Recovery rate probability distribution Creation of a credit loss distribution function Expected credit losses Worst-case credit losses Expected, unexpected, and worst-case credit losses Generalized credit process PDF of future asset value and probability of default Inputs and outputs of the generic credit risk portfolio model Systematic and idiosyncratic credit risks Credit forward to create credit capacity Dynamic credit exposure management 413

14 List of Tables 1.1 Countries amending legislation to accept netting BIS CEM factors, 1988 (percentages) BIS OEM factors, 1988 (percentages) BIS CEM factors, (percentages Best practice self-regulation PMR and AMR over trade life Counterparty risk, market risk, and losses Probabilities and z factors Confidence levels and z factors Sample table of Nikkei risk factors: constant 10% volatility, varying confidence levels Sample table of Nikkei risk factors: constant 97.5% confidence levels, varying volatilities Alternative REE computations Ongoing credit risk of a put option Option risk sensitivities: simple position directional strategies Option risk sensitivities: compound position directional strategies Option risk sensitivities: compound position volatility strategies Synthetic options Synthetic underlyings Complex option variations Barrier options 165 xiv

15 TABLES xv 8.3 Binary barrier option combinations Yield curve scenarios Calculated up/down rate movements (percentages) Calculated rate movements (percentages) Discounted replacement costs Calculated and discounted replacement costs Sample risk factor for interest rate swaps (%) (fixed payer) Federal Reserve/Bank of England Arak, Goodman, and Rones a Whittaker b Whittaker Ferron and Handjinicolaou Hull a Giberti, Mentini, and Scabellone b Giberti, Mentini, and Scabellone Complex swap variations Amortization schedule Average life results (millions) Company ABC credit portfolio Incremental summation approach: sample portfolio Incremental summation approach: sample portfolio Incremental summation approach: sample portfolio Incremental summation approach: sample portfolio Incremental summation approach: sample portfolio Incremental summation approach: sample portfolio Incremental summation approach: sample portfolio Sample portfolio 1 with correlations Sample portfolio 2 with correlations Standard and Poor s cumulative average default rates Moody s cumulative average default rates Moody s one-year default rates, Standard and Poor s one-year transition matrices Moody s one-year transition matrices Default recovery statistics, Summary of credit portfolio risk models Derivatives collateral 389

16 Preface Since the publication of the second edition of The Credit Risk of Complex Derivatives in 1997 the world of derivatives has again gone through a period of very dramatic change in the external operating environment, underlying products and markets, and risk management techniques. Changes in the external operating environment have been dramatic. The global corporate credit environment has deteriorated; after a decade of de-leveraging and re-equitization, a new cycle of leverage (some fuelled by the technology, media, and telecom boom), coupled with an economic slowdown, has brought corporate defaults back to levels not seen since Global stock markets have experienced tremendous bouts of volatility from the late 1990s into the new millennium. Financial and accounting scandals, some ending in bankruptcy, have shaken the corporate world and investor confidence (including Enron, Tyco, Global Crossing, Daewoo, Vivendi, Swissair, and Ahold, among others). The Japanese economy, the second largest in the world, has been crippled by asset deflation and a bad loan crisis for the past decade; Japanese banks and corporations, historically active participants in the derivatives market, have been forced to renegotiate their credit dealing terms to take account of their weakened financial condition. Monetary union has arrived in Europe, causing consolidation of the currency and interest rate markets and growth in pan-european equity and credit investment. xvi

17 PREFACE xvii Emerging market crises have appeared with frequency, impacting local and offshore credit and derivative counterparties (such as those in Mexico in 1994, Korea, Indonesia, Thailand, and Malaysia in 1997, Russia in 1998, Brazil in 1999 and 2002, Argentina in 2000, Venezuela in 2002 and 2003). Systemic credit problems, which spread and deepened throughout the 1990s, continue to plague the banking systems of some Asian countries (Indonesia and Thailand for instance). Hedge funds, always significant derivative players, have been through a boom and bust cycle of their own, culminating in the spectacular bailout of the Long Term Capital Management (LTCM) behemoth by a consortium of international banks in The underlying derivative products and markets have changed in tandem, sometimes in response to macro events: Derivative product availability has increased steadily; new structures (such as volatility swaps, first-to-default swaps, and others) and new asset classes (such as non-catastrophic weather, bankruptcy, and inflation) are now part of the financial marketplace. Once-exotic and unique instruments, such as barrier options and credit default swaps, have become part of the mainstream of financial activity. Some of the pioneering derivative instruments of the early 1980s, such as vanilla interest rate swaps, have become so common and liquid that they are now traded on leading exchanges as listed futures contracts. Overall trading volumes and liquidity have expanded, bid-offer spreads have tightened, and transaction maturities have lengthened. New players have entered different segments of the market (insurance and reinsurance companies, for example, are increasingly active in credit and catastrophe derivatives, and electronic trading networks are delivering vanilla products) while established players are consolidating (for example, mergers of intermediaries, including some long-standing derivative pioneers, have commenced). Derivative-related losses, from market, credit, operational, and legal risks, have continued to mount, but have not yet created broad systemic problems. Special purpose vehicles, including those with embedded derivatives, have come under accounting and regulatory scrutiny.

18 xviii PREFACE To cope with these macro and industry changes, risk management techniques and rules are being redesigned: Credit and market risk exposures are drawing closer together and are increasingly being managed on an enterprise-wide basis. New credit analysis tools and portfolio credit risk models have been developed by industry leaders. Computing power and analytical sophistication have increased, allowing for more timely and accurate quantification and management of exposures. Portfolio management of credit exposures has taken greater hold; sensitivity to credit stress scenarios and correlated counterparty credit exposures is becoming standard operating procedure. Use of collateral, third-party clearing services, and other risk mitigation tools and vehicles has expanded. Derivative documentation standards have been strengthened and clarified, sometimes as a result of disputes and lawsuits; netting of derivatives has gained wider support around the world. New regulatory capital requirements for the credit risks of derivatives have been created, new disclosure rules have been enacted, and accounting treatments have been refined all in hopes of creating more meaningful and equitable consideration of risk and capital. Sensitivity to risk issues including disclosure and governance is on the rise. Clients, intermediaries, and regulators continue to focus on risk education, risk management, and risk disclosure in order to make participation in derivatives more secure, transparent, efficient, and beneficial. Given these changes, and a desire to continue conveying valuable information on the state of the derivative credit risk sector, the second edition of The Credit Risk of Complex Derivatives has been fully revised. The new edition has been substantially reorganized, updated, and expanded. Several new chapters have been added, including: Chapter 2: Derivative Losses. This chapter provides an updated view on market, operational, legal, and credit-related derivative losses. Chapter 3: Risk Governance and Risk Management. This chapter

19 PREFACE xix discusses important board-level and executive management governance requirements related to risk, credit risk, and derivatives. Chapter 4: Regulatory and Industry Initiatives. This chapter outlines unfolding regulatory and industry efforts centered on credit risk, derivatives, capital, and best practice risk management. Chapter 12: Credit Risk Portfolio Models. This chapter reviews advances in next stage portfolio credit risk management tools that have appeared in recent years those applicable to credit sensitive instruments generally (for example, loans and bonds) and derivatives specifically. In addition, the new edition has been updated throughout to convey the latest product and control information. The book includes: Definitions, explanations, and examples of new derivative structures that have appeared in the marketplace in recent years. Discussion of documentation issues, including those that have arisen through formal legal proceedings; this has particular relevance for the credit derivative market, which has been at the center of a host of documentary and definitional issues. Review of alternate transaction and portfolio quantification techniques. As in the second edition, the new edition continues to focus on a volatility-based risk equivalency process as the primary quantification framework for discrete derivative transactions. However, alternative credit quantification techniques based on simulation and option statics, are discussed. Analysis of portfolio risk management models and techniques and capital allocation processes. An expanded and updated glossary. I would like to express my sincere gratitude to Andrea Hartill at Palgrave Macmillan for her support and guidance on this project (as well as many others) over the past decade. Thanks are also due to the production and marketing teams at Palgrave Macmillan. E.B. Redding, Connecticut July 2003 ebbrisk@netscape.net