Authors: Brent W. Ambrose and Zhongyi Yuan
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The New York Innovation Center bridges the worlds of finance, technology, and innovation and generates insights into high-value central bank-related opportunities.
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Economic Policy Review
Pricing Government Credit: A New Method for Determining Government Credit Risk Exposure
Volume 24, Number 3
December 2018
December 2018
JEL classification: H6, H81, R28
A growing debate centers on how best to recognize (and price) government interventions in the capital markets. This study applies a method for estimating and valuing the government’s exposure to credit risk through its loan and guarantee programs. The authors use the mortgage portfolios of Fannie Mae and Freddie Mac as examples of how policymakers could employ this method in pricing the government’s program credit risk. Building on the cost of capital approach, the method captures each program’s possible tail loss over and above its expected value. The authors then use a capital allocation approach to obtain each program’s marginal risk contribution. They show that the current practice of pricing the programs as stand-alone entities overestimates the value of the guarantee. By explicitly capturing the interaction of program losses, their method implies that the government’s overall capital reserve required to insulate taxpayers from losses can be lower than the reserve required when each program is evaluated in isolation. The authors also point out that the extent of this reduction hinges on the strength of (tail) dependence among the expected losses across the programs.
Author Disclosure Statement(s)
Brent Ambrose
I, or my relatives, have not received significant financial support from any interested party related to topics covered in this paper.
I, or my relatives, do not have any positions in relevant organizations [one whose policy positions, goals, or financial interests relate to the article].
No party had the right to review this paper prior to circulation.
Zhongyi Yuan
I, or my relatives, have not received significant financial support from any interested party related to topics covered in this paper.
I, or my relatives, do not have any positions in relevant organizations [one whose policy positions, goals, or financial interests relate to the article].
No party had the right to review this paper prior to circulation.
I, or my relatives, have not received significant financial support from any interested party related to topics covered in this paper.
I, or my relatives, do not have any positions in relevant organizations [one whose policy positions, goals, or financial interests relate to the article].
No party had the right to review this paper prior to circulation.
Zhongyi Yuan
I, or my relatives, have not received significant financial support from any interested party related to topics covered in this paper.
I, or my relatives, do not have any positions in relevant organizations [one whose policy positions, goals, or financial interests relate to the article].
No party had the right to review this paper prior to circulation.
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