Credit Derivatives: Trading, Investing and Risk Management, Second Edition

6

Credit Portfolios and Portfolio Risk

In this chapter we introduce some further terminology applicable to credit risk measurement (VaR and CreditVaR), and we also look at some techniques used to assess the risk on credit portfolios. Detailed understanding of ‘VaR’ approaches are not required for this chapter - see Jorion (2000) or Grayling (1997) for more detailed information.

6.1 VaR AND COUNTERPARTYVaR

Consider an asset. We can calculate a forward value for that asset but are more interested in how far the value can fall below our expected value. More generally we are interested in the distribution of market values, and the low-value tail of this distribution. We shall refer to this concept as ‘VaR’ - we shall assume that we measure this as the deviation of value below the expected value corresponding to a certain percentile of the distribution of the value. Our interest is in credit risky assets - the term ‘creditVaR’ is sometimes used to refer to the risk to value arising from changing credit spreads (or defaults).

Additionally a trade may have counterparty risk - for example, an interest rate swap or a credit default swap has exposure to a counterparty. We can calculate the expected exposure to the counterparty at a forward date, but again our interest may be in how great this exposure to the counterparty could be. In this case we are interested in the high-value tail of the distribution of the asset value at the forward date. We refer to this concept as ‘counterpartyVaR ...