Quantifying Swap Credit Risk

The calculation of swap credit risk exposure continues to be an important topic of discussion at financial institutions and regulatory agencies around the world. Given the complexity of estimating the credit risk of financial contracts whose value changes on a continuous basis, there is no universally accepted fashion by which to assign credit risk exposure to swap transactions; much is dependent on the views of regulators and individual institutions. There are, in general, two broad approaches which must be considered: the calculation of risk exposure for regulatory purposes and the calculation of risk exposure for internal measurement and management purposes. In certain instances these approaches may be identical, particularly if an institution falls under a regulatory jurisdiction which enforces a particular methodology and prefers to apply the same regulatory guidelines to its internal management process. In other instances the approaches may be different; this occurs when there is no governing regulatory guideline or when an institution prefers to utilize regulatory risk calculations for regulatory capital and reporting purposes, and internal risk calculations for internal credit allocation, credit pricing, and risk-adjusted performance purposes. In this chapter we discuss both approaches in general terms (saving a more detailed review of a sample methodology for discussion in Appendix 2). Various concepts developed in this chapter are applied in our discussion of complex swap products in Chapter 7.