Modeling Forward Credit Risk - An Options Approach

9 Pages Posted: 9 May 2007

See all articles by Cho-Hoi Hui

Cho-Hoi Hui

Hong Kong Monetary Authority - Research Department

Abstract

A new Capital Accord (Basel II) proposed by the Basel Committee on Banking Supervision raises the question of how to measure forward credit risk capital charges arising from maturity-mismatched hedges. This article develops a model to measure forward credit risk that is treated as a put option on a firm's asset value with a maturity-mismatched hedge. The hedge is considered a knockout barrier covering part of the put option life. When the firm value breaches the barrier, this triggers the guarantor to provide full protection to the lender. A closed-form formula of this barrier put option is derived and used to calculate forward credit risk premiums. A straight-line method with a premium capital charge and minimum one-year hedge period for treating residual credit risk in maturity mismatches is shown to be conservative and appropriate for the Basel II.

Keywords: Basel II, Forward Credit Risk, Maturity Mismatches

JEL Classification: C60, G13, G28

Suggested Citation

Hui, Cho-Hoi, Modeling Forward Credit Risk - An Options Approach. Journal of Fixed Income, Vol. 9, No. 2, pp. 54-61, 1999. Available at SSRN: https://ssrn.com/abstract=984809

Cho-Hoi Hui (Contact Author)

Hong Kong Monetary Authority - Research Department ( email )

Hong Kong
China

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