Modeling Forward Credit Risk - An Options Approach

A new Capital Accord (Basel II) proposed by the Basel 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 Basel II