Learning Objectives: Compare market risk value at risk (VaR) with credit VaR in terms of definition, time horizon, and tools for measuring them. Define and calculate credit VaR. Describe the use of rating transition matrices for calculating credit VaR.
Questions:
24.17.1. Warren Bank is reassessing its risk management framework. The bank utilizes Value at Risk (VaR) models to calculate both market risk and credit risk exposures as part of its internal risk management practices and regulatory capital requirements. The bank's market risk VaR model is based on a one-day time horizon and uses historical simulation, which captures market data fluctuations and hypothetical changes in the value of its trading portfolio.
For credit risk VaR, the bank is considering an elaborate model that incorporates losses due to defaults, downgrades, and credit spread changes. It acknowledges the importance of credit correlations, especially during economic downturns. Warren Bank uses real-world default probability estimates to develop its scenarios and applies risk-neutral estimates for valuing the portfolio on the VaR horizon date. The bank is also aware that the time horizon for credit risk VaR usually extends to one year, reflecting the nature of instruments not held for trading.
Warren Bank is conducting an annual review of its risk measurement practices. Which of the following statements accurately contrasts market risk VaR with credit VaR?
a. Both market risk VaR and credit VaR use a one-day time horizon for their calculations, aligning the measurement of trading and non-trading instruments.
b. Market risk VaR generally employs historical simulation, while credit risk VaR often requires more complex modeling to account for credit correlation and different types of credit events.
c. The time horizon for market risk VaR is typically longer than that for credit risk VaR, given the need to capture the long-term economic cycles impacting credit events.
d. For credit risk VaR, real-world default probabilities are used to generate scenarios, while risk-neutral probabilities are used to determine regulatory capital requirements.
24.17.2. A credit analyst at Zebracon Bank is assessing the Credit Value at Risk (Credit VaR) for its corporate bond portfolio, valued at $100 million. The bank uses historical data to inform its credit risk modeling, taking into account the likelihood of default and potential credit spread changes over a one-year horizon. The bank aims to calculate the potential loss at a 99% confidence level.
The following information is available:
a. $1,165,000
b. $2,796,000.
c. $1,978,844.
d. $932,000.
24.17.3. Eastender Financial Inc. (‘Eastender’) oversees a diverse bond portfolio spanning credit ratings from AAA to CCC. The risk management team relies on S&P's one-year rating transition matrix to anticipate and manage credit rating changes, focusing on bonds initially rated 'A'.
According to the matrix, there's a 92.61% chance of maintaining the 'A' rating, a 1.67% chance of upgrading to 'AA,' a 5.23% chance of downgrading to 'BBB,' and a 0.05% chance of defaulting within the next year. Eastender remains vigilant of these probabilities while navigating market fluctuations and economic uncertainties. They constantly refine their risk management framework to address emerging challenges and seize opportunities for value creation.
Based on the information provided, how does Eastender strategically use S&P's one-year rating transition matrix to anticipate and manage credit rating changes within their portfolio, considering different time horizons such as five years and one month?
a. Eastender carefully forecasts rating shifts for 'A' rated bonds using the one-year matrix, integrating insights into credit VaR for proactive risk management.
b. Eastender sticks to one-year probabilities, focusing on stability in short-term forecasts to minimize risks.
c. Eastender blends the one-year matrix with macroeconomic indicators for a comprehensive credit risk assessment.
d. Eastender adjusts the one-year matrix for shorter time frames, allowing real-time risk monitoring.
Answers here:
Questions:
24.17.1. Warren Bank is reassessing its risk management framework. The bank utilizes Value at Risk (VaR) models to calculate both market risk and credit risk exposures as part of its internal risk management practices and regulatory capital requirements. The bank's market risk VaR model is based on a one-day time horizon and uses historical simulation, which captures market data fluctuations and hypothetical changes in the value of its trading portfolio.
For credit risk VaR, the bank is considering an elaborate model that incorporates losses due to defaults, downgrades, and credit spread changes. It acknowledges the importance of credit correlations, especially during economic downturns. Warren Bank uses real-world default probability estimates to develop its scenarios and applies risk-neutral estimates for valuing the portfolio on the VaR horizon date. The bank is also aware that the time horizon for credit risk VaR usually extends to one year, reflecting the nature of instruments not held for trading.
Warren Bank is conducting an annual review of its risk measurement practices. Which of the following statements accurately contrasts market risk VaR with credit VaR?
a. Both market risk VaR and credit VaR use a one-day time horizon for their calculations, aligning the measurement of trading and non-trading instruments.
b. Market risk VaR generally employs historical simulation, while credit risk VaR often requires more complex modeling to account for credit correlation and different types of credit events.
c. The time horizon for market risk VaR is typically longer than that for credit risk VaR, given the need to capture the long-term economic cycles impacting credit events.
d. For credit risk VaR, real-world default probabilities are used to generate scenarios, while risk-neutral probabilities are used to determine regulatory capital requirements.
24.17.2. A credit analyst at Zebracon Bank is assessing the Credit Value at Risk (Credit VaR) for its corporate bond portfolio, valued at $100 million. The bank uses historical data to inform its credit risk modeling, taking into account the likelihood of default and potential credit spread changes over a one-year horizon. The bank aims to calculate the potential loss at a 99% confidence level.
The following information is available:
- Portfolio Value: $100 million
- Historical Default Rate: 1%
- Loss Given Default (LGD): 50%
- Credit Spread Volatility: 1.2%
- Z-Score for 99% Confidence Level: 2.33
a. $1,165,000
b. $2,796,000.
c. $1,978,844.
d. $932,000.
24.17.3. Eastender Financial Inc. (‘Eastender’) oversees a diverse bond portfolio spanning credit ratings from AAA to CCC. The risk management team relies on S&P's one-year rating transition matrix to anticipate and manage credit rating changes, focusing on bonds initially rated 'A'.
According to the matrix, there's a 92.61% chance of maintaining the 'A' rating, a 1.67% chance of upgrading to 'AA,' a 5.23% chance of downgrading to 'BBB,' and a 0.05% chance of defaulting within the next year. Eastender remains vigilant of these probabilities while navigating market fluctuations and economic uncertainties. They constantly refine their risk management framework to address emerging challenges and seize opportunities for value creation.
Based on the information provided, how does Eastender strategically use S&P's one-year rating transition matrix to anticipate and manage credit rating changes within their portfolio, considering different time horizons such as five years and one month?
a. Eastender carefully forecasts rating shifts for 'A' rated bonds using the one-year matrix, integrating insights into credit VaR for proactive risk management.
b. Eastender sticks to one-year probabilities, focusing on stability in short-term forecasts to minimize risks.
c. Eastender blends the one-year matrix with macroeconomic indicators for a comprehensive credit risk assessment.
d. Eastender adjusts the one-year matrix for shorter time frames, allowing real-time risk monitoring.
Answers here:
