The measurement of credit exposure to a counterparty focuses on the loss that would occur if the counterparty defaulted, but does not address the probability that a default will occur. To calculate the expected loss or expected worst case loss on derivatives transactions, it is necessary to weight the credit exposure calculations discussed above by the probability of default. Probability-weighted exposure calculations enable the institution to estimate expected default-induced losses. Accordingly, such calculations are useful for measuring return on risk-adjusted capital and for comparing exposures across counterparties.
There are a variety of methods used to calculate loss or expected maximum loss. The simplest approach is to multiply the expected or maximum exposure by specified probability of default factors. An alternative and more complex approach is to run simulation analyses that incorporate a probability of default function. Once again, the degree of sophistication and complexity that is appropriate for measuring expected loss depends on the size and nature of the derivatives portfolio.
Participants use a variety of approaches to estimate the probability that a given counterparty will default. Most dealers, but few end-users, have an independent credit department that provides in-depth credit analyses of the counterparty. This credit research is often augmented by an analysis of credit spreads, bond ratings, and by empirical evidence on actual defaults over a long period in order to estimate the probability of default. In this regard, Standard & Poor´s and Moody´s have carried out extensive studies of defaulting institutions which are frequently used in assessing the probability of default.
The probability of default generally is deemed to be a function of credit ratings and of the maturity of the transaction. These relationships show up strongly in empirical evidence and are borne out in market credit spreads. Specifically, higher rated companies tend to issue bonds with tighter credit spreads than lower rated companies, and tend to default less; credit spreads tend to increase with the maturity of the bond, and the incidence of default tends to increase similarly.
