During 2008, the sudden widening of credit spreads led to a rapid decrease in the value of many financial assets, revealing a general shortage of capital for many financial institutions, with some critical peaks that required fund injection and public bailouts. The evidence of a substantial underestimation of the risk related to a general credit spread widening leads to investigate the reason why risk management systems, in the early stage of the financial crisis, were not able to capture the accumulation of such a high potential of losses. Primarily, it is questioned whether the most unexpected event was the magnitude of the spread widening or, rather, the extent of the price reaction to that factor. The present work is mainly focused on the second front. In particular, it explores the possibility of including in the pricing techniques of financial instruments, a treatment of expected losses that is aligned with the most common methodologies for credit risk evaluation. The refinement of the cash flow mapping techniques leads to detect how, in the phases of severe credit spread widening, modified duration could result in an inaccurate measurement of interest rate risk, but primarily it does not recognize the spread risk in the floater component of a portfolio. A slight revision of the evaluation models allows to identify two specific sensitivity measures, to interest rate and credit spread changes, both functional to the improvement of risk management systems, in order to make them highly sensitive to the spread risk effect.

Applying the common evaluation techniques based on Discounted Cash Flows (DCFs) analysis, the present value of a bond is obtained by discounting the expected cash flows stream F = [f₁, f₂, …, f_n] by an appropriate series of interest rates R = [r₁, r₂, …, r_n].

According to the typical approach, the interest rate vector R is obtained by summing market risk-free rates, extracted from the current yield curve, and an appropriate market credit spread, properly calibrated to offset the default risk of the borrower. This is a very common practice, and yet controversial, not only for the possible inaccuracy in the present value calculation, but also for the significant repercussions on the risk measurement framework. In this formula, the reaction of the present value to the fluctuations of underlying factors is indeed intercepted by a single sensitivity measure, the Modified Duration (MD) that approximates the change in value due to a minimal parallel shift of R.

In this way, we assign to risk-free rate changes and credit spread fluctuations the same potential to affect the present value of a financial instrument, without distinguishing the effects of interest rate risk from spread risk influence. It can be shown that this evaluation approach does not reproduce the real dynamics of market prices that, in fact, react in a different measure to the changes in the two risk classes. As a consequence, we observe a widespread tendency to underestimate the market risk, especially for floating rate debts, with a significant impact on risk measurement systems.

The strong spread widening, caused by the recent credit market turmoil, has led to heavy slumps in the value of financial instruments exposed to the default risk, with no substantial distinction between fixed rate and floating rate loans. This has revealed the insufficiency of the most common sensitivity measures and, at the same time, highlighted the weakness of the typical evaluation approach based on discounting expected cash flows by spread-inclusive market rates.

Financial Risk Management Journal, Risk Management Systems, Credit Risk Evaluation, Financial Instruments, Cash Flow Mapping Techniques, Risk Strategies, Capital Charge Algorithms, Money Market, Credit Default Swap, Risk Evaluation Processes, Fixed Rate Instruments, Financial Transactions, Corporate Bond Prices.