Estimating swap credit risk: significance of the volatility input using Monte-Carlo simulation

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1993
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Virginia Tech
Abstract

Since its inception in the early 1980s, the global market for swaps has grown to over $3 trillion in notional principal outstanding, leading some regulators and others to express concern about risks posed for the financial system. Notional principal, however, is not a measure of the risks of swaps. As a result, it is important to both businesses using swaps and regulators to develop appropriate measures of these risks. For credit risk, for example, current replacement cost measures the credit exposure in the event of default today, but does not account for the possibility of default in the future. Additional measures are required.

This thesis focuses on estimating the credit risk of swaps, accounting for both current and potential future exposure, and measuring the sensitivity or credit risk to changes in volatility. The model used is based on Monte Carlo techniques, drawing on Mark Ferron and George Handjinicolaou's article "Understanding Swap Credit Risk: The Simulation Approach". The model provides an estimate of the expected replacement cost of a swap, averaging across numerous interest rate scenarios. The sensitivity of the model's estimate of swap credit risk to different volatility assumptions is also determined and compared to the results of Ferron and Handjinicolaou.

This analysis demonstrates that swap credit risk is highly sensitive to volatility. For example, starting with a 15% volatility level, a 100 basis point increase in volatility results in a 6.7% increase in the estimate of expected replacement cost. More generally, a given increase in volatility (e.g. from 20% to 25%) results in a proportional increase in replacement cost.

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