Measuring credit risks of derivative instruments helps in evaluating many facets of derivative instruments in the derivative market. It also furnishes information about the market participants. The role of the banks transacting in the derivative markets cannot be ignored as they set the capital standards depending on the credit risks.
Measuring credit risks of derivative instruments is of utmost importance as far as the derivative market is concerned. The participants of the derivative market ought to know the manner in which the pricing should be done in order to compensate for credit risks.
Another factor, which is of utmost importance, is the ability to ascertain the various procedures adopted for reducing credit risks.
A need for precision:
Measurement of credit risks is not only important for the market participants but it is also important for the banks carrying out transactions in the derivative market. Accordingly, the banks can set capital standards. There may be instances when market regulators tend to extend compensation for inaccuracy or imprecision while measuring credit risks. Setting the capital standards in a conservative manner may do this.
Objectives of market participants:
Basically, the derivative market participants aim at achieving the following 3 goals pertaining to management of credit risks.
Valuing default risk
Ascertaining credit exposures in future
Evaluating credit losses in future.
Loopholes in the measuring credit risks of derivative instruments:
There are certain drawbacks in the procedures involved in ascertaining credit risks. An overview of the same follows hereunder.
The first drawback is pertaining to future exposures. When estimation of credit exposure in the future is made as per the Monte Carlo method, the various uncertainties, which prevail while finding out the estimates, are usually not taken into account. The second drawback is pertaining to price related to default risk as well as estimation of future losses. While finding out values for the above two parameters, there are two aspects, which are not taken into account.
Default probability on part of the contracting members
The correlation, which exists among the different derivative instruments.
In practice, there exists a huge correlation among the above two variables and it is believed that in order to ascertain the estimates of credit losses and for the pricing of default risks, the above two variables need to be analyzed in a combined manner.
Last Updated on : 1st August 2013