Modeling Forward Credit Risk — An Option Approach

Abstract

A new Capital Accord recently proposed by the Basle Committee on banking supervision raises the question of how to measure forward credit risk capital charges arising from maturity–mismatched hedges. This article develops a model to measure forward credit risk that is treated as a put option on a firm's asset value with a maturity–mismatched hedge. The hedge is considered a knockout barrier covering part of the put option life. When the firm value breaches the barrier, this triggers the guarantor to provide full protection to the lender. A closed-form formula of this barrier put option is derived and used to calculate forward credit risk premiums. A straight-line method with a premium capital charge and minimum one-year hedge period for treating residual credit risk in maturity mismatches is shown to be conservative and appropriate for the proposed Capital Accord.