Managing the Risk of Embedded Options in Non-Traded Credit Using Portfolio Modeling

23 Pages Posted: 13 Aug 2019 Last revised: 6 May 2022

See all articles by Bernd Engelmann

Bernd Engelmann

Ho Chi Minh City Open University

Date Written: Mai 04, 2022

Abstract

A framework for measuring and managing the risk of embedded options in non-traded credit is developed. For typical bank clients there is no market information related to their ability to pay (bond or CDS spreads) available. The absence of market information is a key assumption of this article. In this case, a bank has to rely solely on statistical data to judge the credit quality of a borrower. To value a loan with embedded options like prepayment rights, a model is proposed that combines an interest rate derivatives pricing model with statistical information on default and recovery rates. Using this for evaluating the risk of embedded options in loans, it is shown how the concepts of credit risk management can be applied after defining a suitable concept of risk. It turns out that this modeling framework combines the theories of derivatives pricing and credit risk modeling in the sense that derivatives pricing theory measures the costs for hedging optional components in loans while credit risk modeling measures the risk that these hedging costs turn out to be inadequate. This risk depends not only on the single loan’s risk characteristics but also on the dependence structure and the granularity of the total loan portfolio.

Keywords: Loan, Non-traded Credit, Embedded Options, Option Pricing, Credit Portfolio Modeling, Credit Risk Management

JEL Classification: G12, G13

Suggested Citation

Engelmann, Bernd, Managing the Risk of Embedded Options in Non-Traded Credit Using Portfolio Modeling (Mai 04, 2022). Available at SSRN: https://ssrn.com/abstract=3434776 or http://dx.doi.org/10.2139/ssrn.3434776

Bernd Engelmann (Contact Author)

Ho Chi Minh City Open University ( email )

Ho Chi Minh City
Vietnam

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