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“ Substitution risk” Rocco Letterelli Marco Ticciati Msc in Finance

“ Substitution risk” Rocco Letterelli Marco Ticciati Msc in Finance. Substitution risk. Definition : “ risk of greater cost sostitution of the asset afforded by one part if the couterpart makes a default before the settlement date”

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“ Substitution risk” Rocco Letterelli Marco Ticciati Msc in Finance

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  1. “Substitution risk” Rocco Letterelli Marco Ticciati Msc in Finance

  2. Substitutionrisk Definition: “ riskofgreatercostsostitutionof the assetaffordedbyone part if the couterpartmakes a default before the settlement date” In the financiallecteraturethereisrelationshipswith Pre-settlementrisk Conterpartyrisk

  3. Itis a kindofriskwhichwehave in hedgingpositions • Itisobservableto OTC derivative markets • Needformark-to-marketmonitoringoffinancial position COST OF SUBSTITUTION ESTIMATION CURRENT EXPOSURE Substitutionrisk

  4. Substitutionriskmeasurement: 2 questions: If a counterparty was to default today, what would it cost to replace the derivatives transaction (i.e., what is the current exposure)? If a counterparty defaults at some point in the future, what is a reasonable estimate of the potential replacement cost (i.e., what is the potential exposure)?

  5. 1) the first answerisquite intuitive and itisrepresented by mark-to-market value of the underlyingcontract. Example: 5y swap • fixed rate 6% • floating rate of LIBOR. • The mark-to-market value is zero at t0 Suppose that t=0,5 the swap rate for a 4.5-year swap is 5.50%. If the counterparty paying the fixed rate of 6.00% defaults, the nondefaultingcounterparty receiving the fixed rate (and paying the floating rate) will be forced to replace it with a 5.50% swap and will thereby suffer a replacement cost equal to 0.50% per annum for the remaining 4.5 years Substitutionrisk:

  6. 2)The second question is more difficult to answer in that it asks for an assessment of what the replacement cost could be in the future • Dealers use Monte Carlo or historical simulation studies, option valuation models, and other statistical techniques to assess potential exposure. These techniques are often used to generate two measures of potential exposure: expected exposure; and maximum or "worst case" exposure Substitutionrisk:

  7. Expected exposure at any point during the life of the swap is the mean of all possible probability-weighted replacement costs, where the replacement cost in any outcome is equal to the mark-to-market present value if positive and zero if negative. • The maximum potential exposure is calculated as an estimate of "worst case" exposure at any point in time 2 importantmeasures:

  8. Thisshapeis due to 2 differenteffects: Diffusioneffects: as the time progresses the probability to have MKT far from zero increases (volatility of underlying) Amortizationeffect: the reduction in years of cash flowsthatneed to be replaced

  9. regulation… Substitutionrisk

  10. AccordingtobaselIthere are twoapproachesto estimate counterpartyrisk • Basel II treated CCR loss as credit risk • The secondoneaccountsforsubstitutionrisk • Itisbased on Substitutionrisk

  11. the CE is given by the current market value (MV) of the OTC contract, that is, by the cost the bank would face to replace the contract (“substitutioncost”) with an identical one, if the counterparty were to default. If the market value is negative, then there is no current exposure to credit risk, and CE is set to zero. To this CE, an estimate of FPE must be added, given by a fixed percentage (p) of the notional (N). The value of p, also called the “add-on” factor, depends on the underlying asset and increases with the maturity of the contract. LEE = CE + FPE = max(0,MV ) + p ·N Substitutionrisk

  12. After the crisis… Basel III Basel III has incorporated credit value adjustment (CVA) that is therisk premium from the counterparty to be compensated for the risk of the counterparty defaulting , in calculations of regulatory capital for counterparty credit risk(CCR) Substitutionrisk

  13. Basel III applies a hybrid approach in terms of CCR regulation by treating default risk and credit migration risk differently: the default risk is treated as creditrisk under the ASRF framework (with capital horizon H = 1 year and confidence level q = 99.9%), while the credit migration risk is treated as market risk Substitutionrisk

  14. Therefore, in the last regulationframework MORE WEIGHT TO THE MARKET FEATURE OF CONTERPARTY RISK MORE WEIGHT OF SUBSTITUTION RISK Substitutionrisk

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