On measuring credit risks of derivative instruments

This paper critically reviews current practices for measuring credit risks of derivative instruments. It argues that there are three major problems with the standard measurement approach. First, it uses models of the stochastic behavior of financial variables while ignoring both their inherent oversimplification and the uncertainty in their parameters. Second, it ignores the correlations between exposures on derivative instruments and the probabilities of counterparty default. Third, it estimates upper bounds on credit losses associated with a given derivative instrument without regard to the composition of the portfolio of which the instrument is a part. This paper demonstrates that these practices can produce large errors in the measurement of both expected credit losses and upper bounds on these losses.

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