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 language | English |
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Pages (from-to) | 69-95 |
Number of pages | 27 |
Journal | Journal of Risk Model Validation |
Volume | 12 |
Issue number | 4 |
DOIs | |
Publication status | Published - 2018 Dec 1 |
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