Application of VaR to Non-Market Areas
Financial Institutions are often faced with risks other than normal market risk. That is especially true with derivative transactions. In derivative transactions, institutions need to increase their estimate of allowable loss amount by incorporating the following risks:
- Pre-settlement risk
- Settlement risk
Pre-settlement risk is the risk that a counterparty will default on a derivative transaction prior to the contract’s settlement at expiration (payment risk).
Settlement risk is a risk that a counterparty will default on a derivative transaction on the counterparty’s settlement (closing risk).
Attempts to mitigate these risks are known as bilateral payment netting and bilateral closing netting. By recognizing these risks institutions are attempting to estimate a value for this risk component and incorporate it into their calculations.
Aside from the trading business of financial institutions, recent attempts have been made to apply VaR concepts to the loan side.
A loan made to counterparty exposes a financial institution to credit risk. Credit risk is defined as the risk resulting from uncertainty in a counterparty’s ability or willingness to meet its contractual obligation.
In assessing credit risk from a counterparty, an institution must consider two issues:
- Credit Quality: This encompasses both the likelihood of the counterparty defaulting as well as possible recovery rates in the event of a default.
- Credit Exposure: In the event of a default, what is the replacement cost of the counterparty’s outstanding obligations likely to be?
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