Rethinking the margin period of risk

Leif Andersen; Alexander Sokol; Michael Pykhtin

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Need to know

The proposed model captures legal and operational aspects of default in considerably greater detail than models currently used.
The model often produces significantly higher - and spikier -- credit exposure for representative portfolios compared to the currently used models.
To efficiently capture exposure at the required resolution, practical computational techniques are discussed in detail.

Abstract

We describe a new framework for modeling collateralized exposure under an International Swaps and Derivatives Association Master Agreement with a Credit Support Annex. The proposed model captures the legal and operational aspects of default in considerably greater detail than the models currently used by most practitioners while remaining fully tractable and computationally feasible. Specifically, it considers the remedies and suspension rights available within these legal agreements, the firm's policies in availing itself of these rights and the typical time it takes to exercise them in practice. The inclusion of these effects is shown to produce significantly higher credit exposure for representative portfolios than do the current models. The increase is especially pronounced when the dynamic initial margin is also present.

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