Creditmetrics and Constant Level of Risk (September 2010)
12 Pages Posted: 14 Nov 2010
Date Written: September 8, 2010
In this paper I develop a framework to think through the interpretation an important piece of the new Basel guidelines for setting trading book capital. This piece – the Incremental Risk Charge (IRC) – is intended to cover default and migration risks in the trading book. Any bank that already has approval to use their internal models to set VaR-based trading book capital will be required to come up with an IRC model by the end of 2011. An important aspect of the IRC framework is the provision that positions are rebalanced over the annual horizon so as to maintain a Constant Level of Risk. Much of the model development comes down to how to interpret and implement this provision. I discuss three distinct mechanisms by which rebalancing impacts risk, and present the ideas of how our modeling framework captures each of these. I then perform a benchmarking exercise, applying our model to a number of representative portfolios in order to assess the impact of each of the rebalancing mechanisms. Finally, I compare the results from our model to the capital from the Basel banking book model (the IRB), as well as another IRC model from the literature. This exercise can serve as a template for how we could use our model (and product) to benchmark client or prospect portfolios.
Keywords: CreditMetrics Constant Level of Risk new Basel guidelines for setting trading book capital the Incremental Risk Charge IRC VaR model development model product benchmark
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