Managing the risk of embedded options in non-traded credit using portfolio modeling

Bernd Engelmann ()
Additional contact information
Bernd Engelmann: Ho Chi Minh City Open University, Faculty of Finance — Banking, 35-37 Ho Hao Hon Street, District 1, Ho Chi Minh City, Vietnam

International Journal of Financial Engineering (IJFE), 2023, vol. 10, issue 03, 1-26

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 paper. 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 (search for similar items in EconPapers)
JEL-codes: G12 G13 (search for similar items in EconPapers)
Date: 2023
References: Add references at CitEc
Citations:

Downloads: (external link)
http://www.worldscientific.com/doi/abs/10.1142/S2424786323500123
Access to full text is restricted to subscribers

Related works:
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:wsi:ijfexx:v:10:y:2023:i:03:n:s2424786323500123

Ordering information: This journal article can be ordered from

DOI: 10.1142/S2424786323500123

Access Statistics for this article

International Journal of Financial Engineering (IJFE) is currently edited by George Yuan

More articles in International Journal of Financial Engineering (IJFE) from World Scientific Publishing Co. Pte. Ltd.
Bibliographic data for series maintained by Tai Tone Lim ().