credit risk portfolio models

[aditya]

hi david,

nice briefcasts on basel II !!!!!!


i have few doubts on creditmetrics

how does creditmetrics use these things in calculating portfolio risk.

1)The term structure of interest rates-
(is it because it uses forward curves to calculate terminal value of assets but at the same time it is being said that for swaps average exposure is taken in the model, is it because the calculations which we are performing are static and not dynamic in nature)

2) Rating drift-
(is it because we are using a ratings migration matrix and then proceeding forward)

3) Spread risk-
(plz explain this, is it incorporated in the model?? and what is spread risk)

4) The negative correlation between the Treasury rates and credit spreads(how it is incorporated in the model)

and at last how is credit spread( is it used to generate a correlation matrix for the asset returns used as one of the factor in the model??

BEST WISHES
ADI

 

[aditya]

hi david,

i have many problems in understanding crpm, could you plz help me out with the above question or suggest what should i refer to get my doubts clear on this topic....


many thanx
adi

 

[David Harper CFA FRM]

Hi adi,

I am planning to screencast next week on credit risk portfolio models, please watch the blog.

I attached the creditmetrics technical document; not to recommend the whole thing, but the intro is a complete overview. Every other author you'll find is copying from this intro

Here is a link to a draft XLS i created that illustrates credit metrics (I will screencast over this). , but only for a single bond. This captures the first major step but certainly not the harder second step, portfolio aggregation. Maybe looking at the three sub-steps in the XLS will help...

1. The forward curve (see step 2 in XLS) is used to discount the bond, one year forward, at each rating grade
2. rating drift. Yes, note rating matrix gives probability that bond will migrate to a different grade
3. spread risk is risk that spreads will widen (risky yield - riskless) and lower credit value (due to higher discount rate). hmmm...typically we have said CM does not capture this, only PRT. CM captures migration via the matrix, but i don't *think* it captures (stochastic) spread changes...historically, following de servigny we have said CM captures defaults & migrations but not spreads. (I don't have time to double check this now, please verify)
4. I don't understand this reference and i don't think it's central to CM. Credit spreads can be used to infer joint probabilities, but this is a deeper feature... oh i see, that is your last point....yea, maybe i will try and address what you mean next week, but i think maybe you are one layer too deep, for learning. First (and even this will not be tested), maybe look at start of Chapter 3 in CM technical document. There are two broad steps in CM: how to get loss distribution for a single credit, then how to extend to multiple credits. Chapter 3 serves this up; i think your last reference is to detail method within the portfolio. But, esp for exam, you first just want a high level view.

David