Ali’s blog

Mostly quant stuff with occasional digressions

Estimating exposures in credit derivatives

Posted by alifinmath on January 29, 2008

Some points Chris Prouty was making yesterday being echoed by Robert Pickel (chief executive of the International Swaps and Derivatives Association) in a piece in the FT:


In recent weeks, otherwise sophisticated commentators have made some basic yet potentially damaging errors about the amount of risk exposure held via credit derivatives. These assumptions, including those made by William Gross, Pimco’s chief executive, significantly overstate net settlement flows that would result on default of “underlying” entities. There is a danger this might create a climate of fear in financial markets in which companies, including Pimco, operate and which are already dealing with severe market volatility.

Critically, these errors ignore conventional market use of economically offsetting positions, which reduces the amounts at stake sharply. We seek here to illustrate some more down-to-earth assumptions; not to forecast the future. This is how the numbers really work:

First, the $50,000bn “notional” or nominal amount is just that; a nominal figure that references the “underlying” bonds and loans being protected by use of credit derivatives.

Focus on the net exposure of these transactions, many of which hedge or offset one another. A recent Fitch Ratings survey estimates net exposure at less than $1,000bn.

Factor in a probability of default of 2 per cent and a 25 per cent recovery rate and protection sellers would have to settle an aggregate $15bn of losses.

None of these amounts would be “lost” to the system; a credit derivative simply transfers a potential gain/loss from one party to another. Clearly, while $15bn is not trivial, it is a small fraction of aggregate write-offs to date on loans and securities; and less than a 10th of Mr Gross’s suggestion.

And our figures are conservative: we use a slightly higher ($50,000bn) figure for the total reference amounts; we round up the net exposure figure; we use a higher default rate than the 1.25 per cent used elsewhere; and our projected recovery rate is much lower than the 50 per cent used by Mr Gross.



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