Exposure at default under basel II and III

Abstract

The main reason for the financial crisis 2008 in the worldwide banking systems was the ignorance of the counterparty credit risk (CCR). In response, the Basel Committee on Banking Supervision introduced a new credit valuation adjustment (CVA) capital framework to mitigate this risk and also strengthen capital profile of banks. The objective of the thesis was to investigate an approach to an exposure at default (EAD), which is the most essential input for many capital frameworks in Basel regulations, especially for the CVA capital one. After a few chapters providing some adjacent conceptual background, the main consideration was about the calculation of the EAD for the OTC interest rate swap (IRS) contracts portfolio under current exposure method. The EAD calculation was totally executed by an automatic calculator, which was self-programmed by the thesis’ author in R programming language. Also, a valuation of mark-to-market value of the IRS and the construction of a zero-curve for discounting swap’s cash flows were fully analysed. The data sample for EAD calculation was a generated portfolio of the OTC IRS contracts referenced by some characteristics of the standardized contracts in the US exchange. Using the market data of USD-Libor spot rate and Eurodollar Futures (April 27, 2017), I could construct the zero-curve by combining the linear interpolation and bootstrapping methods for specifying a mark-to-market value of each swap contract, and hence the EAD. Finally, the benefit of netting and collateral on EAD value was proven by experimental results and comparisons. Keywords: Basel III, Credit Valuation Adjustment, Counterparty Credit Risk, Exposure at Default, Current Exposure Method, OTC Derivatives, Interest Rate Swap, Netting, Collateral. v