CREDIT RISK AND CREDIT VALUE-AT-RISK
Credit risk emerged as a significant risk management issue in the 1990s. In increasingly competitive markets, banks and securities houses are taking on more forms of credit risk. The following are instances:
- credit spreads tightened in the late 1990s and the early part of 2000 to the point where blue chip companies – such as BT or Shell – benefitted from syndicated loans for as little as 10–12 basis points over the London Interbank Offered Rate (Libor); banks are turning to lower rated firms to maintain margin;
- growth in complex financial instruments that are more chal lenging to manage than traditional instruments, such as credit derivatives;
- investors are finding fewer opportunities in interest rate and currency markets and moving towards yield enhancement through extending and trading credit; for example, after EMU, participating government bond markets become credit markets;
- high yield (junk) and emerging market sectors have been expand ing rapidly.
The growth in credit exposures and rise of complex instruments have led to a need for more sophisticated risk management techniques.
TYPES OF CREDIT RISK
There are two main types of credit risk:
- credit spread risk;
- credit default risk.
Credit spread risk
Credit spread is the excess premium required by the market for taking on a certain assumed credit exposure. Credit spread risk ...