An integrated benchmark model for Counterparty Credit Risk

Master thesis (2023)

Authors

T.P.S. Heijnders Electrical Engineering, Mathematics and Computer Science

Contributors

Cornelis Vuik Delft Institute of Applied Mathematics (mentor)
A. Papapantoleon Applied Probability - EEMCS (graduation committee member)
F. Fang Numerical Analysis - EEMCS (coach)
Xiaoyu Shen (coach)
Faculty
Electrical Engineering, Mathematics and Computer Science, Electrical Engineering, Mathematics and Computer Science
Copyright: © 2023 Tom Heijnders
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Published Date

18-01-2023

Language

English

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Faculty

Electrical Engineering, Mathematics and Computer Science

Abstract

The EAD metric is widely used in the calculations for the capital requirements concerning Counterparty Credit Risk (CCR). In this thesis we compare several methods for calculating this EAD. Basel III gives us two methods, the Standardized Approach for CCR (SA-CCR) and the Internal Model Method (IMM). Furthermore, we introduce an integrated benchmark model, whereby we estimate the EAD by integrating the Wrong Way Risk (WWR) directly, while in SA-CCR and IMM this WWR is captured by an alpha factor of 1.4. In this benchmark model, we derive the formula for backing out the probability of default using CDSs and then, via a Gaussian copula, we include a correlation between the exposures and default probability to model the WWR. The ultimate goal of this thesis is to find out how conservative the SA-CCR is compared to the IMM and the integrated benchmark model, and if the alpha factor of 1.4 is a reasonable value to account for WWR.

The test portfolios consist of interest rate swaps, cross currency swaps and FX forwards, which are the most liquid product types in the market. To value these products we model the interest rate using the Hull-White model and the exchange rate using a GBM, following industry standard.

Testing results suggest that the SA-CCR is at least a factor of 1.5 more conservative than the IMM in the presence of collateral, even with stressed parameters. The level of conservatism is even higher because no diversification is allowed between different asset classes by SA-CCR. Furthermore, we observe that using the parameters backed out from calibration and a default correlation of about 30 to 40\%, our integrated benchmark model based on copula returns more or less comparable EADs of IMM times the alpha factor of 1.4. This indicates that this value of 1.4 is a reasonable value to cover WWR in the IMM framework.