CreditMetrics Methodology and Credit Value at Risk (Credit VaR)

Abstract

Described by Hull (2011, 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. Changes in debt value could be small in case of credit quality ratings change; however, they could be enormous, 50% to 90%, in case of default. Characterized by a long downside tail, credit-returns are highly-skewed and fat-tailed and thus far from the Gaussian normal distribution assumptions about market risk in VaR (Fig. 1). In the portfolio context, based upon correlation of credit quality moves across obligors, CreditMetrics assesses both value-at-risk (VaR), i.e., the volatility of value, as well as expected losses (EL). By distinguishing high quality well-diversified portfolios from low-quality concentrated portfolios, it offers better understanding of credit risk in terms of diversification benefits and concentration risk compared to mandated standard capital adequacy measures.