The Valuation of Credit Risk in Swaps

Department of the Istitirto Mobiliare Italian0 in Rome. nancial institutions are more and more concerned with the credit risk of off-balance-sheet instruments. The valuation of derivative products has so F far been based on the assumption of no default risk, although the credit risk inherent in such instruments can have important implications for the management of risk exposure. Quantifying a “credit equivalent” for off-balance sheet operations allows a financial institution to determine the absorption of credit lines and to monitor exposure limits. In other words, it enables institutions to 1) include these operations in their general system of loan risk management, and 2) evaluate the results of their various activities in light of allocated capital. This article first discusses the nature of credit exposure of derivative securities, and outlines some standardized valuation criteria proposed by regulatory authorities. We then use historical data to quantify the effective credit exposures of various types of currency and interest rate swaps. Monte Carlo simulations allow valuation of the potential exposure bounds as a function of both residual life and the currency in which contracts are denominated. The resulting grid of Salues for particular types of swaps provides a tool for a prudent measurement of credit risk.