Exposure At Default During Financial Stress - A Comparative Study

Abstract: In recent years the capital requirements for banks have been updated which has complicated the pricing procedure for derivatives. Nordea has developed a proxy model that approximates the risk measure Exposure At Default, which is an important component in the recently updated requirements. The purpose of this thesis is to validate the accuracy of Nordea’s model. In order to fulfill this purpose, models for the Exposure At Default calculations are developed and implemented in both the risk neutral probability measure and the real world probability measure. Both models are based on time consuming Monte Carlo simulations. To improve speed a third, analytical solution in the risk neutral probability measure, is developed as well. The result shows that the two models in the risk neutral probability measure converge towards the same value, as the number of simulations in the Monte Carlo model increases. There is a difference in the results generated in the two measures which is assumed to depend on the absence of the risk premium in the real world probability measure. The final conclusion is that Nordea’s proxy model does not generate trustworthy results. However, considering this conclusion, Nordea was able to improve their proxy model to generate accurate results.