A framework to measure integrated risk

Elena Medova and Robert Smith

Quantitative Finance, 2005, vol. 5, issue 1, 105-121

Abstract: A framework underlying various models that measure the credit risk of a portfolio is extended in this paper to allow the integration of credit risk with a range of market risks using Monte Carlo simulation. A structural model is proposed that allows interest rates to be stochastic and provides closed-form expressions for the market value of a firm's equity and its probability of default. This model is embedded within the integrated framework and the general approach illustrated by measuring the risk of a foreign exchange forward when there is a significant probability of default by the counterparty. For this example moving from a market risk calculation to an integrated risk calculation reduces the expected future value of the instrument by an amount that could not be calculated using the common pre-settlement exposure technique for estimating the credit risk of a derivative.

Keywords: Risk measurement; Market risk; Credit risk; Pre-settlement risk; Integrated risk; Structural credit models; Economic capital; Foreign exchange forward (search for similar items in EconPapers)
Date: 2005
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Citations: View citations in EconPapers (5)

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DOI: 10.1080/14697680500117583

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