taking advantage of Credit Portfolios Making use of Systemic Risk Evaluation
High systemic correlation and exposure indicates high systemic risk losses and vice versa. An optimal portfolio should be balanced based on these two systemic parameters.
The value of financial instruments within a portfolio or account is driven by a combination of three factors: market conditions, counterparty status, and the behavioural 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 fulfil contractual obligations – fictional assumptions.
This mix of facts and fictional expectations is included in credit spreads used in 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 impacts the value of a 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 behaviour of the counterparties, investors or portfolio managers can change the value of instruments unexpectedly.
These three financial analysis elements, market risk factors, counterparty credit risk and behaviour, are correlated between themselves and reinforced by interactions 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 analysed on the counterparties systemic risk.
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