Contingent Credit Research Articles

Design of a Socially Inclusive Climate Risk Transfer Mechanism: A Case Study in La Guajira, Colombia

The primary aim of this study was to develop a model of a socially inclusive climate risk insurance (CRI) mechanism based on the differential risk transfer approach. This study focused on the department of La Guajira, Colombia, as a case study. La Guajira is the department in Colombia that, due to its critical disaster risk conditions, presents the adequate configuration for implementing a climate risk transfer mechanism. The article starts by analyzing risk conditions by using secondary data. Based on fieldwork, this research explored the perspectives of the most vulnerable sectors in La Guajira Department on the socioeconomic impacts and needs they experience regarding climate-related hazards, their adaptive measures for risk reduction, and their willingness to adopt CRI. This represents the fundamental input for the formulation of the CRI model. Consequently, this research proposed an operational structure as input for future implementations of the model. The results indicate that national and local disaster risk management public policies align with the sectors’ needs and priorities. Strengthening sectoral associations can enhance representation in CRI projects. In-kind indemnization is preferred for women entrepreneurs and the indigenous community. The CRI model includes a risk pool through the family compensation fund of La Guajira as a sectoral agglomerator, with contingent credit and traditional/parametric insurance. The methodology developed in this study can be applied in different contexts worldwide as a guidance for informing national and international climate risk finance initiatives.

The Impact of Risk Contingent Credit and Traditional Credit on Smallholders’ Agricultural Investment, Productivity and Welfare: Experimental Evidence from a Randomized Control Trial in Rural Kenya

The Impact of Risk Contingent Credit and Traditional Credit on Smallholders’ Agricultural Investment, Productivity and Welfare: Experimental Evidence from a Randomized Control Trial in Rural Kenya

Risk-contingent credit for sovereign disaster risk finance

After natural disasters, governments in developing countries often depend largely on humanitarian aid from donors and Development Finance Institutions (DFI). At the same time disaster affected developing countries repay public loans to donors and DFI (ODA loans). It is, hence, plausible to assume that risk contingent credit (RCC) which is widely discussed in agricultural and development economic literature might also bear potential for sovereign disaster risk finance. RCC allow a partial debt relief if ex ante defined risk events (e.g., natural disasters) occur. There would be especially potential for RCC if ODA loans are not risk-contingent. This study therefore tests for the countries of the West African Economic and Monetary Union (WAEMU) and based on panel data estimations with natural disaster, humanitarian aid, and public debt repayment data 1) if WAEMU countries depend on humanitarian aid after natural disasters, and 2) if in disaster years partial debt reliefs are granted with ODA loan repayments. The study finds that in disaster years WAEMU countries depend on humanitarian aid which is provided but with a slight delay after the natural disaster has occurred. Furthermore the study finds no evidence for natural disaster-related debt relief on ODA loan repayments in WAEMU countries. Hence WAEMU countries continue repaying ODA loans in disaster years whilst at the same time they receive humanitarian aid. The average ODA loan repayment in the investigated period for the WAEMU countries would be sufficiently high to provide WAEMU governments with enough means to respond to natural disasters. RCC could, hence, be an interesting disaster risk financing instrument for WAEMU countries. The development of disaster contingent financial instruments such as RCC was highlighted by the United Nations, the International Monetary Fund and also the 2018 G7 summit.

Optimal investment and pricing in the presence of defaults

AbstractWe consider the optimal investment problem with random endowment in the presence of defaults. For an investor with constant absolute risk aversion, we identify the certainty equivalent, and compute prices for defaultable bonds and dynamic protection against default. This latter price is interpreted as the premium for a contingent credit default swap, and connects our work with earlier articles, where the investor is protected upon default. We consider a multiple risky asset model with a single default time, at which point each of the assets may jump in price. Investment opportunities are driven by a diffusion X taking values in an arbitrary region . We allow for stochastic volatility, correlation, and recovery; unbounded random endowments; and postdefault trading. We identify the certainty equivalent with a semilinear parabolic partial differential equation with quadratic growth in both function and gradient. Under minimal integrability assumptions, we show that the certainty equivalent is a classical solution. Numerical examples highlight the relationship between the factor process, market dynamics, utility‐based prices, and default insurance premium. In particular, we show that the holder of a defaultable bond has a strong incentive to short the underlying stock, even for very low default intensities.

Credit contingent interest rate swap pricing

Credit value adjustment (CVA) is an adjustment to an existing trading price based on the counterparty-risk premium. Currently, CVA is computed with an implicit assumption that the replacement contract is default-free after the original counterparty defaults, with the assumption that those trades will not re-assigned. In the actual counterparty default settlement, it is the norm that trades will be re-assigned, especially on the buy side. Since the counterparty of the replacement contract could also default within the lifetime of an existing contract, ignoring the possibility of counterparty defaults of replacement contracts will either under or over estimate the cost of the risk. An important practical question is, therefore, how to estimate under/over pricing of CVA under current practice.In this paper, we considered the pricing of credit contingent interest rate swap (CCIRS) or credit contingent default swap (CCDS), which is considered the CVA hedge for interest rate swaps (IRS). We derived partial differential Eqs. (PDEs) satisfied by the approximated CVA with the assumption that the replacement contracts do not default. For comparison purposes, we also derived the PDEs for the cost of CVA by relaxing the assumption of default-free replacement contracts with a finite number of counterparty defaults. It shows that the no-default and two default cases can be derived within the same analytical solution framework, similar to the Funding Valuation Adjustment (FVA) problem where continuous funding is a reasonable assumption. The finite number of default case is non-trivial. The PDE for the two default case is derived in this paper.We calibrate our model based on market data and carry out extensive computations for the purpose of comparing these three CVAs. Our basic finding is that the values of the two CVAs are close for top rated counterparties. On the other hand, for counterparties with lower credit ratings, the difference among the two CVAs can be significant.

Disaster Risk Financing in Bangladesh

Disasters pose considerable challenges not only to livelihoods but also to economy. Financial protection from disasters, i.e., disaster risk financing, has increasingly been applied in developed countries. However, the application of ex ante disaster risk financing is very scarce in developing countries including Bangladesh. Bangladesh is disaster-prone, with floods and cyclones being the most frequent and severe danger. Based on historical data, natural hazard events in Bangladesh cost more than $10 billion economic losses from 2000 to 2013, but the total funding available for relief, rehabilitation, and reconstruction for the same period was $2 billion only. It is estimated that Bangladesh will incur a financial impact of about $3.2 billion on average per year due to cyclone and flood, or about 2.2% of gross domestic product. Bangladesh urgently needs to develop ex ante disaster risk financing solutions to minimize economic impacts of catastrophes. Currently, three disaster risk finance solutions are considered effective in Bangladesh: sovereign disaster risk contingent credit, parametric sovereign risk insurance, and disaster risk microfinance portfolio insurance.

Comprehensive Study of Kisan Credit Card at Central Bank of India-A Useful Credit Tool for Rural Development

The KCC is pioneering credit delivery innovative products which provide a adequate and timely credit to farmers' thorough single window, with flexible and simplified procedure, adopting whole farm approach, including the short-term credit, medium term and long term credit needs of the borrowers for agriculture and allied activities and a reasonable component for consumption needs. The Government of India introduced KCC scheme by banks during 1998-1999. It was designed by NABARD. KCC aims at adequate and timely support from the banking system to the farmers for their short-term production credit needs in cultivation of crops, purchase of inputs etc in a flexible and as well as cost effective manner. Under this scheme, the appliers would be issued a credit card-cum pass book incorporating the name, address, particulars of land holding, borrowing limit, validity period etc and it will serve both as an identity card as well as facilitates the financial transactions. Credit limit of the card may be fixed on the basis of operational holding, cropping pattern and scale of finance as recommended by the DLTC&SLTC. As per the recommendations of Sri R.V. Gupta committee in the year 1998, on the flow of credit to agricultural sector, apart from the total credit need, a 20 per cent of total peak level credit requirement (PLCR) there is provision of contingent credit need (with a minimum ceiling of Rs.20,000). Normally The KCC should valid up to 5 years and subject to annual review. The KCC will be considered as a nonperforming asset (NPA) if it remains inoperative for a period of two successive crop seasons.

Contingent credit default swaps: accurate and approximate pricing

In this paper, we analyze the pricing of contingent credit default swaps (CCDSs), which provide protection against default losses in derivative transactions. In a framework with both asset and interest rate risk, we obtain a meaningful semi-analytical solution for CCDS prices with an interest rate swap as underlying. Our model yields three major contributions.1. CCDSs have several properties that fundamentally differ from those of CDSs, despite the similar nature of the two instruments.2. We propose simple approximate pricing formulas for CCDSs. While the first one only depends on the prices of observable traded assets, i.e., the CDS quote, the value of a swaption and a zero bond, the second approximation formula additionally requires volatility information.3. We find that the approximate formulas work well in practical situations and converge to the true value for a financial institution with low default risk.

The Attalid victory at Magnesia on a lost plaque from Pergamon

AbstractThis article explores the battle scene on a small bronze plaque recovered during the 19th-century excavation of Pergamon, initially published in 1913 and subsequently lost. It argues that the most likely identification of the scene is the Battle of Magnesia, fought in 190 BC. The scene features Attalid cavalry riding to the rescue of distressed Roman legionaries, both fighting in opposition to Antiochus the Great's heavy phalanx and Gallic cavalry. The heroics of the Attalid cavalry are central to the scene, and likely reflect a courtly narrative that gave Eumenes II and his small contingent outsized credit for the joint victory.

A heterogeneous agent model of credit-linked index insurance and farm technology adoption

Protection from downside risk is a determinant of technology uptake among subsistence agricultural households. Access to credit, insurance and savings may stimulate technology adoption where new methods are riskier but higher-yielding or require sunk costs. In this paper, we employ a dynamic, stochastic, heterogeneous agent model where farm households have access to contingent credit and make savings, technology and loan repayment choices. Our approach is novel as insurance is modeled as a meso-level product, where the bank is indemnified before any payouts are distributed to borrowers; thus, it accounts for both supply- and demand-side concerns, showing a flow of effects when index insurance contracts are sold to risk aggregators for whom basis risk is lower. Results show letting the lender lay first claim on indemnities lowers default, which can decrease interest rates and expand credit access. Insurance and savings may also spur technology uptake.

COUNTERPARTY RISK AND FUNDING: THE FOUR WINGS OF THE TVA

The credit crisis and the ongoing European sovereign debt crisis have highlighted the native form of credit risk, namely the counterparty risk. The related credit valuation adjustment (CVA), debt valuation adjustment (DVA), liquidity valuation adjustment (LVA) and replacement cost (RC) issues, jointly referred to in this paper as total valuation adjustment (TVA), have been thoroughly investigated in the theoretical papers [8, 9]. The present work provides an executive summary and numerical companion to these papers, through which the TVA pricing problem can be reduced to Markovian pre-default TVA BSDEs. The first step consists in the counterparty clean valuation of a portfolio of contracts, which is the valuation in a hypothetical situation where the two parties would be risk-free and funded at a risk-free rate. In the second step, the TVA is obtained as the value of an option on the counterparty clean value process called contingent credit default swap (CCDS). Numerical results are presented for interest rate swaps in the Vasicek, as well as in the inverse Gaussian Hull-White short rate model, which allows also to assess the related model risk issue.

Small businesses and risk contingent credit

PurposeFirms facing significant income volatility can often suffer from downside risk such that return on assets is insufficient to meet fixed financial obligations. The purpose of this paper is to provide a prescriptive credit solution for small businesses facing exogenous income risk.Design/methodology/approachFormulas for risk‐contingent operating and collateralized loans are developed and simulated in the context of a specific business sector.FindingsThe paper demonstrates that a structured credit product with an imbedded option can reduce or eliminate financial risks by providing payouts that decrease the amount of principal and/or interest that firms must repay under low income states.Originality/valueThe overall objective of this paper is to provide a means to mitigate exogenous income risk faced by firms through the design and application of a risk‐contingent credit product that is tied to primary markets and simple to implement. In this context, risk contingency credit refers to a suite of financial products with payoff schedules (loan principal) that are linked to specific commodities or indices. The authors are in fact unaware of any commercial financial products of the type considered in this paper and thus their approach is a prescriptive solution to the identified problem.

Parsimonious exposure‐at‐default modeling for unfunded loan commitments

Purpose – The purpose of this paper is to build an easy to implement, pragmatic and parsimonious yet accurate model to determine an exposure at default (EAD) distribution for CCL (contingent credit lines) portfolios.Design/methodology/approach – Using an algorithm similar to the basic CreditRisk+ and Fourier Transforms, the authors arrive at a portfolio level probability distribution of usage.Findings – The authors perform a simulation experiment which illustrates the convolution of two portfolio segments to derive an EAD distribution, chosen randomly from Moody's Default Risk Service (DRS) database of CCLs rated as of 12/31/2008, to derive an EAD distribution. The standard deviation of the usage distribution is found to decrease as we increase the number of puts used, but the mean value remains relatively stable, as the extreme points converge towards the mean to produce a shrinkage in the spread of the distribution. The authors also observe, for the sample portfolio, that an increase in the additional u...

Counterparty Risk FAQ: Credit VaR, PFE, CVA, DVA, Closeout, Netting, Collateral, Re-Hypothecation, WWR, Basel, Funding, CCDS and Margin Lending

We present a dialogue on Counterparty Credit Risk touching on Credit Value at Risk (Credit VaR), Potential Future Exposure (PFE), Expected Exposure (EE), Expected Positive Exposure (EPE), Credit Valuation Adjustment (CVA), Debit Valuation Adjustment (DVA), DVA Hedging, Closeout conventions, Netting clauses, Collateral modeling, Gap Risk, Re-hypothecation, Wrong Way Risk, Basel III, inclusion of Funding costs, First to Default risk, Contingent Credit Default Swaps (CCDS) and CVA restructuring possibilities through margin lending. The dialogue is in the form of a Q&A between a CVA expert and a newly hired colleague. JEL classication

Debt Sustainability Measures and Their Explanatory Power for Estimating Government Bond Yields

The purpose of this article is to explain changes in sovereign yields using conventional “rating agency style” measures in comparison to contingent claims valuation-based measures. I will show that – in contrast to most conventional sovereign credit quality measures – contingent claims valuation-based credit measures have significant power in explaining the spread between 10-year sovereign yields and the expected future monetary policy rate.

An Application of Risk Contingent Credit Applied to New York Dairy Farms with U.S. Options on Class III Milk Futures

This paper addresses the financial risks faced by New York dairy farmers by discussing and developing prescriptive risk-contingent operating and mortgage loan contracts. It is argued that structured credit products with an imbedded contingent claim or price put option can effectively reduce or eliminate financial risks by providing payouts that reduce the amount of principal and/or interest that the farmer must repay under low price states. Formulas for risk-contingent operating and mortgage loans are developed and simulated.

The Design of Micro Credit Contracts and Persistent Access to Credit Constraints of Micro Enterprises in Uganda

Contractual arrangements in microfinance are designed to overcome the problems of adverse selection and moral hazard that are prevalent in developing and low income countries. Micro credit lenders use “innovative” lending methods such as group lending, contingent credit and use of collateral substitutes to provide credit to those unable to borrow from mainstream financial institutions such commercial banks. However, despite growth of the microfinance industry in terms of outreach and product development, the businesses at the bottom end - micro enterprises - still face considerable access to credit constraints. A study of micro enterprise access to credit in Uganda revealed limiting factors such as the evolving nature of micro credit and its providers, the lack of flexibility in structuring micro loans, and the negative perceptions about loan application and screening processes. In addition, harsh expected consequences of default, the disincentives of contingent credit, and the blind sanctioning of default also negatively impact access to credit. The study involved 602 micro enterprises located in various parts of Uganda and 105 lending institutions including commercial banks, credit institutions, microfinance deposit taking institutions, microfinance non-deposit taking institutions and Savings and Credit Cooperatives and Savings and Credit Societies.

Collateral Free Lending with Risk-Contingent Credit for Agricultural Development

This paper investigates a viable alternative to traditional credit products through the development of risk-contingent credit for operating loans and farm mortgages and applies the concept to agricultural loans for pulse crops in India. We analyze daily commodity spot prices and design risk contingent structured financial instruments. Risk contingent credit mitigates business and financial risk by reducing debt obligations depending on the embedded commodity options whose payoffs are linked with commodity price fluctuations.

An Exposure at Default Model for Contingent Credit Line

In-spite of large volume of Contingent Credit Lines (CCL) in all commercial banks paucity of Exposure at Default (EAD) models, unsuitability of external data and inconsistent internal data with partial draw-down, has been a major challenge for risk managers as well as regulators for managing CCL portfolios. Current paper is an attempt to build an easy to implement, pragmatic and parsimonious yet accurate model to determine exposure distribution of a CCL portfolio. Each of the credit line in a portfolio is modeled as a portfolio of large number of option instrument which can be exercised by the borrower determining the level of usage. Using an algorithm similar to basic CreditRisk+ and Fourier Transforms we arrive at a portfolio level probability distribution of usage.

Effects of Self-Recording and Contingent Credit on Balancing Participation Across Students

This study compared the effects of students’ (a) receiving participation credit with and without self-recording their participation and (b) self-recording participation with and without receiving credit for participation on the percentage of students functioning at four participation levels: non-participation, credit-level participation, frequent participation (slightly above credit-level), and dominant participation (2.5+ times above credit-level). Participants came from three sections of a relatively large discussion course (initially 55 students per section). Credit (with and without self-recording participation) decreased the percentage of both non-participants and dominant participants and increased the percentage of credit-level participants, thus creating greater balance in participation across students in each class. In contrast, self-recording versus non-self-recording (with and without credit) did not significantly differentiate the percentages of either non-participants or frequent participants but did differentiate the percentages of credit-level and dominant participants under the recording conditions.