Quantitative Risk Management: A Practical Guide to Financial Risk, + Website

11.2 Credit Risk versus Market Risk

Earlier chapters focused primarily on market risk, so it is useful to highlight some differences between credit risk and market risk. The difference center around specific issues: first, the time frame over which we measure the P&L distribution—it is much longer for credit risk; second, the asymmetry and skew of the P&L distribution—credit risk leads to highly skewed distributions; third, the modeling approach—P&L for credit risks must usually be modeled from first principles rather than from observed market risk factors; finally, data and legal issues become relatively more important. We review each of these briefly before turning to a simplified model of credit risk.

Liquidity and Time Frame for Credit versus Market Risk

Although the P&L distribution is the primary focus for both market risk and credit risk, the time frame over which P&L is evaluated is often substantially longer for credit risk than for market risk. This is primarily a result of the illiquidity of most credit products. Credit products, loans being the classic example, have traditionally not been traded, and institutions have held them until maturity. Furthermore, credit events tend to unfold over a longer time horizon than market events. Information on credit status changes over weeks and months, not minutes and hours as for market variables. For these reasons, measuring P&L for credit risk over a period of days or weeks is usually inappropriate because there is no practical ...