CreditMetrics Methodology and Credit Value at Risk (Credit VaR)

Abstract

Financial institutions are subject to many sources of risk, where risk often represents the degree of uncertainty about future net returns. Credit Risk can result in potential loss due to the inability of a counterparty to meet its obligations and is a function of the credit exposure, the probability of default and the loss in the event of default. For a given credit instrument portfolio of Credit obligations such as a portfolio of corporate bonds or swaps, Credit Value-at-Risk (VaR) quantifies how much at most can be lost with a given probability over a specific time horizon (Malhotra 2015). The associated CreditMetrics Methodology, originally introduced in 1997 by JP Morgan has become the “de facto industry standard” along with Credit VaR for credit risk modeling among global financial institutions as well as their regulators (Malhotra 2022). Described by Hull (2011 and 2012) as ‘a procedure for calculating credit value at risk’, CreditMetrics methodology (RiskMetrics Group, 2007) is used for assessing portfolio risk due to changes in bond or debt value caused by credit quality changes, including credit migration (upgrades and downgrades) as well as default. It measures the uncertainty in forward value of the bond portfolio at the risk horizon caused by such credit events. By distinguishing high quality well-diversified portfolios from low-quality concentrated portfolios, CreditMetrics offers better understanding of credit risk in terms of diversification benefits and concentration risk compared to standard capital adequacy measures.

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Malhotra, Yogesh. Framework of Credit Metrics Methodology for Computing Credit VaR, IUP Journal of Financial Risk Management. Sep2022, Vol. 19 Issue 3, p 38-49. 12p.

© Copyright Dr. Yogesh Malhotra, www.YogeshMalhotra.com. All Rights Reserved, 2022.

Keywords: Credit Risk, CreditMetrics, Credit VaR, VaR, Value at Risk, Transition Matrices, Credit Ratings, Forward Pricing, Forward Price Curves, Fixed Income, Bonds, Bond Defaults, Credit Defaults, Economic Capital, Diversification

JEL Classification: A, C, E, G, P, Z