Today, topic is a Modern Approach to Counter party Credit Risk. The topic of counter party credit risk IS one of the things, that you discussed in this content. It was the introduction of really the modern approach for counter party credit risk can you uh just share with us. What is that approach as especially since so many people are thinking about it and then what are other approaches in the market and why is numerics following this approach.
A Modern Approach to Counter party Credit Risk
Basically there are two main approach is to counter party risk currently in the market. One can be called as a traditional approach, which was appeared to well long ago. It’s a consists of two steps on the first step. You’ll generate scenarios and then on the second step very well your portfolio for counter party risk to compute all exposures but recently a an approach appeared which we which is a modern approach it appeared at around two thousand twelve to 2010. It’s a based on it could be called chasm modeling approach, it generates scenarios actually by using arbitrage free models and main components of that approach our hybrid models.
There is a requirement that all the correlations between all asset classes have to be incorporated, when a computing counter party risk. You have to have collaborative models. The second component the second component of that approach is a the universal Monte Carlo method, that could be applied across all these hybrid models and that method is the American Monte Carlo methods. So these two components, so one would assume in terms the approaches. There’s always trade-offs in terms of time performance and and especially in differences of instruments where more are like structured products or more exotic water risk factors that would require a hybrid model versus something that would be just more plain vanilla straightforward in terms of analytic pricing within this approach.
How are you handling? You know both the Vanilla’s any more exotic type of instruments. There are different different optimization, that can be applied to these types of instruments even though the modern approach is universal across all the instruments. It is very important point of course for vanilla part of your portfolio. You it’s better to have some methods etta therefore much faster than than general hybrid models. In that content, we implemented the what we call super swap optimization. The aggregation of all cash flows across a large portfolio super small large portfolios vanilla swaps and representing this portfolio as a single instrument that leads to performance. Well much faster computation without a without sacrificing any accuracy, and on on the unstructured product side.
You’ve interested introduced something called an algorithmic exposure. You walk us through that a little bit right within the modern approach still, what we introduced in our paper which is a working paper available on-line. We call it algorithmic exposure, that means the following for structured product. You normally have to express their payoff of the instrument in some kind of payoff language or script language. There are different names for that, but its its present in in every trading system in some form. The first version of standard version of modern approach used the modification of that script to compute exposures. It adds a lot to operational risk and what we came up with either, what we call algorithmic exposure in our approach. You don’t have to change all your existence script for structure deals exotic deals.
You can reuse those scripts and you compute exposures is a byproduct of rice computation, it involves a non-trivial analytics and to be able to do that in a at the time of Christ computation. It can be proved rigorously that the result will be exactly the same but you don’t have to change anything. It’s very fast way to market to compute exposure and in terms of the the Monte Carlo simulation itself. There’s been advancements in terms of the American Monte Carlo in in order to do the simulations in computations within that framework is that correct. It was something that you’ve implemented a while ago correct and yes well at numerix q years ago excellent all right well surrogate.