Vulnerability of Risk Management Systems in Credit Spread Widening Scenarios

Abstract

During 2008, the sudden widening of credit spreads led to a rapid decrease in the value of many financial assets, revealing a general shortage of capital for many financial institutions, with some critical peaks that required fund injection and public bailouts. The evidence of a substantial underestimation of the risk related to a general credit spread widening leads to investigate the reason why risk management systems, in the early stage of the financial crisis, were not able to capture the accumulation of such a high potential of losses. Primarily, it is questioned whether the most unexpected event was the magnitude of the spread widening or, rather, the extent of the price reaction to that factor. The present work is mainly focused on the second front. In particular, it explores the possibility of including in the pricing techniques of financial instruments, a treatment of expected losses that is aligned with the most common methodologies for credit risk evaluation. The refinement of the cash flow mapping techniques leads to detect how, in the phases of severe credit spread widening, modified duration could result in an inaccurate measure of interest rate risk, but primarily it does not recognise the spread risk in the floater component of a portfolio. A slight revision of the evaluation models allows to identify two specific sensitivity measures, to interest rate and credit spread changes, both functional to the improvement of risk management systems, in order to make them highly sensitive to the spread risk effect.