CHAPTER 21 Credit Value at Risk

The value at risk measure is central to the determination of regulatory capital for credit risk and to much of the credit risk management carried out internally by both financial and nonfinancial corporations. This chapter covers alternative approaches for calculating credit risk VaR.

Credit risk VaR is defined similarly to market risk VaR. It is the credit risk loss over a certain time period that will not be exceeded with a certain confidence level. Some credit risk VaR models consider only losses from defaults; others consider losses from downgrades or credit spread changes as well as from defaults.

Banks calculate credit risk VaR to determine both regulatory capital and economic capital. The regulatory capital requirements for credit risk are discussed in Chapters 15 and 16. Economic capital, which is discussed in Chapter 26, is a financial institution's own estimate of the capital it requires for the risks it is taking and is used to calculate return on capital measures for its business units. Sometimes the VaR model that a bank chooses to use to determine credit risk economic capital is different from the one it is required to use for the determination of regulatory capital.

Value at risk is a scenario analysis measure. As explained in Chapter 7, the probability of default estimates used to develop alternative horizon-date scenarios should therefore be real-world estimates. Risk-neutral estimates should then be used to value the underlying ...

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