Credit Value at Risk

Chapter 18

Risk Management and Financial Institutions 3e, Chapter 18, Copyright John 1C. Hull 2012
 Rating Transitions
One year rating transition probabilities are
published by rating agencies.
If we assume that the rating transition in one
period is independent of that in other periods we
can calculate the rating transition for any period
(see Appendix J and software)
The ratings momentum phenomenon means
that the independence assumption is not
perfectly correct

Risk Management and Financial Institutions 3e, Chapter 18, Copyright John C.
2 Hull 2012
 One-Year Rating Transition
Matrix (% probability, Moodys 1970-2010)
Table 18.1 page 401

Initial Rating at year end

Rating Aaa Aa A Baa Ba B Caa Ca-C Default
Aaa 90.42 8.92 0.62 0.01 0.03 0.00 0.00 0.00 0.00
Aa 1.02 90.12 8.38 0.38 0.05 0.02 0.01 0.00 0.02
A 0.06 2.82 90.88 5.52 0.51 0.11 0.03 0.01 0.06
Baa 0.05 0.19 4.79 89.41 4.35 0.82 0.18 0.02 0.19
Ba 0.01 0.06 0.41 6.22 83.43 7.97 0.59 0.09 1.22
B 0.01 0.04 0.14 0.38 5.32 82.19 6.45 0.74 4.73
Caa 0.00 0.02 0.02 0.16 0.53 9.41 68.43 4.67 16.76
Ca-C 0.00 0.00 0.00 0.00 0.39 2.85 10.66 43.54 42.56
Default 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 100.00

Risk Management and Financial Institutions 3e, Chapter 18, Copyright John C.
3 Hull 2012
 Five-Year Rating Transition
Matrix (calculated from one-year transitions)
Table 18.2 page 401

Initial Rating at end

Rating Aaa Aa A Baa Ba B Caa Ca-C Default
Aaa 61.12 7.70 0.89 0.21 0.05 0.01 0.00 0.03
Aa 3.45 29.99
61.89 28.7 4.71 0.73 0.25 0.07 0.01 0.19
A 0.44 9.72 0
65.7 18.88 3.24 1.06 0.24 0.04 0.60
Baa 0.22 1.69 8
16.38 60.98 4.64 0.97 0.13 2.06
Ba 0.07 0.44 3.40 12.93 20.0 3.70
44.6 0.52 8.92
B 0.04 0.20 0.83 18.20
3.27 913.28 7 1.64
Caa 0.01 0.08 0.23 0.93 3.52 43.05
16.8 11.49
18.67 2.93 26.21
56.84
Ca-C 0.00 0.02 0.06 0.31 1.39 05.89 6.78 2.40 83.15
Default 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 100.00

Risk Management and Financial Institutions 3e, Chapter 18, Copyright John C.
4 Hull 2012
 One-Month Rating Transition
Matrix (calculated from one-year transitions)
Table 18.3 page 401

Initial Rating at month end

Rating Aaa Aa A Baa Ba B Caa Ca-C Default
Aaa 99.16 0.82 0.02 0.00 0.00 0.00 0.00 0.00 0.00
Aa 0.09 99.12 0.77 0.01 0.00 0.00 0.00 0.00 0.00
A 0.00 0.26 99.18 0.51 0.04 0.01 0.00 0.00 0.00
Baa 0.00 0.01 0.44 99.05 0.41 0.06 0.02 0.00 0.01
Ba 0.00 0.00 0.02 0.59 98.46 0.79 0.03 0.01 0.09
B 0.00 0.00 0.01 0.02 0.53 98.32 0.70 0.07 0.36
Caa 0.00 0.00 0.00 0.01 0.02 1.01 96.79 0.67 1.48
Ca-C 0.00 0.00 0.00 0.00 0.04 0.28 1.53 93.23 4.92
Default 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 100.00

Risk Management and Financial Institutions 3e, Chapter 18, Copyright John C.
5 Hull 2012
 Credit VaR (page 321)
Can be defined analogously to Market
Risk VaR
A one year credit VaR with a 99.9%
confidence is the loss level that we are
99.9% confident will not be exceeded over
one year

Risk Management and Financial Institutions 3e, Chapter 18, Copyright John C.
6 Hull 2012
 Vasiceks Model (Equation 18.1, page 402)
For a large portfolio of loans, each of which has
a probability of Q(T) of defaulting by time T the
default rate that will not be exceeded at the X%
confidence level is
N 1 Q (T ) N 1 ( X )
N
1

Where is the Gaussian copula correlation

Risk Management and Financial Institutions 3e, Chapter 18, Copyright John C.
7 Hull 2012
VaR Model (Equation 18.2, page 402)

VaR WCDR i (T , X ) EAD i LGD i

i

Risk Management and Financial Institutions 3e, Chapter 18, Copyright John C.
8 Hull 2012
 Credit Risk Plus (Section 18.3, page 403)
This calculates a loss probability distribution using a
Monte Carlo simulation where the steps are:
Sample overall default rate
Sample probability of default for each counterparty
category
Sample number of losses for each counterparty category
Sample size of loss for each default
Calculate total loss from defaults
This is repeated many times to calculate a probability
distribution for the total loss

Risk Management and Financial Institutions 3e, Chapter 18, Copyright John C.
9 Hull 2012
 CreditMetrics (Section 18.4, page 405)
Calculates credit VaR by considering
possible rating transitions
A Gaussian copula model is used to
define the correlation between the ratings
transitions of different companies

Risk Management and Financial Institutions 3e, Chapter 18, Copyright John C.
10Hull 2012
 The Copula Model : xA and xB are sampled from
correlated standard normals

Risk Management and Financial Institutions 3e, Chapter 18, Copyright John C.
11Hull 2012
 Credit Risk in the Trading Book: The
Specific Risk Charge

To calculate the specific risk charge,

banks must model credit spreads to
calculate a 10-day 99% VaR
Alternatives:
Historical simulation
10-day transition matrix

Risk Management and Financial Institutions 3e, Chapter 18, Copyright John C.
12Hull 2012
 Credit Risk in the Trading Book:
Incremental Risk Charge
Banks must calculate a one year 99.9%
VaR
This is to ensure that capital is similar to
the capital that would be charged if the
instrument were in the banking book
They are allowed to make a constant level
of risk assumption (minimum liquidity
horizon is three months)
Risk Management and Financial Institutions 3e, Chapter 18, Copyright John C.
13Hull 2012
 Constant Level of Risk
Assumption
Suppose a bank has a BBB bond and
uses a liquidity horizon of 3 months
At the end of each month period the bond,
if it has deteriorated is assumed to be sold
and replaced with a new BBB bond
The one-year loss is then replaced by four
three-month losses

Risk Management and Financial Institutions 3e, Chapter 18, Copyright John C.
14Hull 2012