Measuring Credit Spread Risk: Incorporating the Tails

Abstract

It is widely known that the small but looming possibility of default renders the expected return distribution for financial products containing credit risk to be highly skewed and fat tailed. In this paper, we apply recent techniques developed for incorporating the additional risk faced by changes in swap spreads. Using data from the US, UK, Germany, and Japan, we find that the risk faced from large spread widenings and tightenings is grossly underestimated. Estimation of swap spread risk is dramatically improved when the severity of the fat tails is measured and incorporated into current estimation techniques.

Keywords: Market risk, value-at-risk, extreme value theory, parametric distributions, backtesting

JEL Classification: M, M41, G3, G24