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One common approach during the relevant years for estimating
credit exposure was a Monte Carlo simulation. The basic idea of
this approach was to construct a mathematical model to simulate
thousands of variations of future movements of a certain interest
rate (e.g., 6-month LIBOR rate) and, for each variation, to
calculate the credit exposure at numerous points (e.g., every 3
months over the life of the swap). The model generated a
probability distribution of exposure amounts for each swap, which
was used to calculate maximum exposures for multiple confidence
intervals.
3. Market Data for Pricing Credit Risk of Bonds
The credit quality of an issuer of bonds affects the fair
market value of the bonds. If a bond is traded, this
relationship can be directly observed in the price of the bond.
Data on the market prices of traded bonds can be used to
estimate the fair market value of nontraded bonds, inclusive of
any premium or discount that should be applied for credit risk.
Public databases exist which gather information on the traded
prices and yields for bonds with different credit ratings and at
different maturities. This information is gathered, and an index
of yields is constructed. The value of a nontraded bond is
calculated by discounting the promised cashflows at the yield for
the index of comparably rated bonds with the same maturity.
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