Contract Behavior Risk Models
In earlier sections, we discussed market risk, where all contracts in a simulation experience the same projected market values, leading to consistent and aggregatable cash flows and events. However, real-world financial contracts are also influenced by contract-specific and counterparty behaviors, introducing additional uncertainty.
Market Risk vs. Behavior Risk
| Market Risk | Behavior Risk |
|---|---|
| Affects all contracts equally in a simulation | Varies by contract and counterparty |
| Future market values are the same for all contracts | Future cashflows depend on contract-specific factors |
| Independent of a contract's internal state | Can be influenced by contract terms, counterparty credit rating, and market conditions |
Factors Affecting Contract Behavior Risk
- Contract terms – e.g., prepayment options, credit limits
- Additional attributes – borrower’s credit rating, contract’s business area
- Internal contract state – time to maturity, current interest rate
- Market conditions – future interest rates, liquidity changes
Examples of Contract Behavior Risks
1. Prepayment Risk
Some loan contracts permit early repayment, which reduces expected interest income for lenders.
2. Counterparty Default
A borrower defaults, terminating the contract early, often resulting in principal loss.
3. Deposit/Withdrawal Risk
Depositors withdraw funds or credit counterparties draw on available credit, affecting liquidity.
4. American Option Exercise Risk
An American Option holder can choose the time to exercise, impacting future cashflows.
ACTUS Risk Modeling
ACTUS includes a basic Prepayment Risk Model for ANN and PAM contracts.
However, real-world risk models are more complex, involving multiple parameters and various modeling approaches.
Unlike core ACTUS simulations, which produce a single deterministic future cashflow, behavior risk models evaluate different possible outcomes based on contract-specific factors.
Conclusion
Understanding contract behavior risks is essential for accurate financial modeling. While market risk provides a broad view, behavior risks introduce real-world variability that must be considered in risk assessments.