Optimizing Credit Portfolios Using Systemic Risk Analysis
by Ioannis Akkizidis, Global Product Manager, Wolters Kluwer Financial Services’ FRSGlobal
The value of financial instruments within a portfolio or account is driven by a combination of three factors; market conditions, counterparty status, and behavioral characteristics of the two aforementioned factors. Current market prices and yields are defined based on factual analytics, however, their future characteristics are driven by expectations - or in other words by “fictional assumptions”. The quality of counterparties is defined by credit risk characteristics and is commonly expressed as ratings – again a factual measurement. However, ratings also reflect the willingness of the counterparty to fulfill contractual obligations – fictional assumptions.
This mix of facts and fictional expectations is included in credit spreads used in the financial instruments and thus the portfolio valuation process. Finally, the market and counterparty behaviour such as the recovery process, in case of default; or the funding liquidity for selling the financial contracts/instruments also impact the value of the portfolio. Behaviour is not always driven by the facts but in many cases by emotional characteristics. Such emotions under stress conditions could even go beyond the universe of reality; for instance the rational behavior of the counterparties, investors or portfolio managers can change the value of the instruments unexpectedly.
These three financial analysis elements; market risk factors, counterparty credit risk and behaviour, are correlated between themselves and interaction among each other. Thus, the degrees of such correlations and interactions must be identified and considered in the valuation process of the financial instruments within a portfolio. Such complex process under the current stress conditions can be analyzed on the counterparties’ systemic risk.