Evaluating the credit exposure of interest rate derivatives under the real-world measure

Takashi Yasuoka

    Research output: Contribution to journalArticle

    Abstract

    This paper examines the credit exposure evaluation properties of interest rate derivatives to manage counterparty credit risk, working with the real-world probability.We briefly introduce the Heath-Jarrow-Morton (HJM) model and the Hull-White (HW) model in connection with real-world modeling. In a backward-looking approach, a real-world model is constructed from a combination of interest rate model and historical data of forward rates. By using data from the Japanese London Interbank Offered Rate/swap markets and considering three sample periods, we construct a number of real-world models: specifically, theHWmodel, the one-factor HJM model, the threefactor HJM model and other variations. The exposure profiles of interest rate swaps are calculated from the forward-rate scenarios simulated by our real-world models. We compare the results of applying the above models, using three sample periods from the viewpoint of model validation. As a result, the potential future exposure profile under the real-world simulation reflects the volatility structure and the historical drift of the forward rates. In contrast, the risk-neutral model does not reflect the historical drift, but it does reflect the volatility structure.

    Original languageEnglish
    Pages (from-to)69-95
    Number of pages27
    JournalJournal of Risk Model Validation
    Volume12
    Issue number4
    DOIs
    Publication statusPublished - 2018 Dec 1

    Fingerprint

    Derivatives
    Interest rate derivatives
    Credit
    Heath-Jarrow-Morton model
    Forward rates

    Keywords

    • Counterparty credit risk (CCR)
    • Interest rate model
    • Interest rate risk management
    • Market price of risk
    • Potential future exposure
    • Real-world simulation

    ASJC Scopus subject areas

    • Modelling and Simulation
    • Finance
    • Economics and Econometrics
    • Applied Mathematics

    Cite this

    Evaluating the credit exposure of interest rate derivatives under the real-world measure. / Yasuoka, Takashi.

    In: Journal of Risk Model Validation, Vol. 12, No. 4, 01.12.2018, p. 69-95.

    Research output: Contribution to journalArticle

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