Backtesting counterparty credit exposure based on the Heath, Jarrow and Morton framework for simulation of interest rates

Abstract

In this thesis a framework for backtesting counterparty credit exposure is developed and implemented. Using the Heath, Jarrow and Morton model for simulation of interest rates, separate models are implemented for risk-neutral pricing of interest rate derivatives, and for simulation of future real-world interest rates. The models are combined to simulate distributions of credit exposure for a simple swap contract between a financial institution and a typical counterparty. The implemented framework is discussed with respect to practical use, model assumptions, and potential improvements.

The results show that the model performs well in most periods, but fails to capture the impact of the unprecedented low interest rates prevailing after the financial crisis. A proposed improvement of the model is to increase the volatility of the real-world interest rate model to better capture unexpected future events.