Simulations in Finance

Authored by: Manish Shirude

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1. Counterparty Credit Risk Simulation
Counterparty Credit Risk (CCR) is the risk that a party to a derivative contract may default prior to the
expiration of the contract and fail to make the required contractual payments.

If one party of a contract defaults, the non-defaulting party will find a similar contract with another
counterparty in the market to replace the default one. That is why counterparty credit risk sometimes
is referred to as replacement risk.

The replacement cost is the MTM value of a counterparty portfolio at the time of the counterparty
default.

Why Simulation is Required?

“CCR has been widely considered as one of the key drivers of the 2007-08 financial crisis.”

Post 2007-08 financial crisis, counterparty credit risk become one of the main focuses of major global
and U.S. regulatory frameworks. Understanding counterparty credit risk help financial institutions set
the counterparty credit limits and policy, which help mitigate losses when the credit events occur.

What tools and techniques available?

Some vendors and institutions use this simplified approach. Only a couple of stochastic processes are
used to simulate all market risk factors.

Risk managers commonly use various mathematical techniques to quantify and assess counterparty
credit risk, including:
- Simulating default events using Copulas
- Estimating transition probabilities of credit ratings
- Pricing of financial instruments (e.g., swaps, options, forwards)

Tools and methods available for CCR simulation:

- MATLAB
- Financial Toolbox™
- Financial Instruments Toolbox™
- Risk Management Toolbox™
- Monte Carlo methods for counterparty credit risk estimation

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Conclusion

Pricing and measuring counterparty credit risk is computationally extremely extensive.

Credit exposure (CE) is the cost of replacing or hedging a contract at the time of default. Simulation is
needed here as Credit exposure in future is uncertain. To calculate credit exposure or replacement
cost in future times, one needs to simulate market evolutions. Simulation must be conducted under
the real-world measure.

Other measures, such as potential future exposure (PFE), expected exposure (EE), expected positive
exposure (EPE), effective EE, effective EPE and exposure at default (EAD), can be derived from credit
exposure (CE).

I will suggest MATLAB solution for risk management which provides comprehensive portfolio of
inbuilt toolbox for every credit risk simulation requirement.