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Introduction
CreditRisk+ is a statistical credit risk model launched by Credit Suisse First Boston (CSFB) in 1997. CreditRisk+ can be applied to any type of credit product, including loans, bonds, financial letters of credit and derivatives.
Analytical techniques
CreditRisk+ uses analytical techniques, as opposed to simulations, to estimate credit risk. The techniques used are similar to those applied in the insurance industry. CreditRisk+ makes no assumptions about the cause of default.
It models credit risk based on sudden events by treating default rates as continuous random variables.
Data requirements
Exposure Default rates
Methodology
Model the frequency of default events Model the severity of default losses
CreditRisk+ accounts for the correlation between different default events by analyzing default volatilities across different sectors, such as different industries or countries. This method works because defaults are often related to the same background factors, such as an economic downturn. To estimate credit risk due to extreme events such as earthquakes, CreditRisk+ uses stress testing. For low probability events that can't be covered under the statistical model, it uses a scenario-based approach.
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CreditRisk+ concerns itself with sudden default as opposed to continuous change when estimating credit risk.
Poisson Distribution
CreditRisk+ uses the Poisson distribution to model the frequency of default events. The Poisson distribution is used to calculate the probability that a given number of events will take place during a specific period of time. The Poisson distribution is useful when the probability of an event occurring is low and there are a large number of debtors. For this reason, it is more appropriate than the normal distribution for estimating the frequency of default events.
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Sector analysis
Each sector is driven by a single underlying factor, which explains the volatility of the mean default rate over time. Through sector analysis, CreditRisk+ can measure the impact of concentration risk and the benefits of portfolio diversification. As the number of sectors is increased, the level of concentration risk is reduced.
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Stress Testing
Stress tests can be carried out in CreditRisk+ and outside CreditRisk+.
CreditRisk+ can be stress tested by increasing default rates and the default rate volatilities and by stressing different sectors to different degrees. Some stress tests, such as those that model the effect of political risk, can be difficult to carry out in CreditRisk+.
In this case, the effect should be measured without reference to the outputs of the model.
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Applications of CreditRisk+
Calculating credit risk provisions Enforcing credit limits
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When credit losses are modelled, the most frequent loss tends to be much lower than the estimated average loss. This is because the estimated average takes into account the risk of occasional extreme losses. Credit provisions, also known as economic capital, need to be set aside to protect against such losses. CreditRisk+ can be used to set provisions for credit losses in a portfolio.
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Managing Portfolios
CreditRisk+ incorporates all the factors that determine credit risk into a single measure.
CreditRisk+ provides a means of measuring diversification and concentration by sector. More diverse portfolios with fewer concentrations require less economic capital.
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Credit Metrics
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Introduction
CreditMetrics was launched by JP Morgan in 1997 It evaluates credit risk by predicting movements in the credit ratings of the individual investments in a portfolio. CreditMetrics consists of three main components:
Historical data sets A methodology for measuring portfolio Value at Risk (VAR)
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Data requirements
Credit ratings for the debtor Default data for the debtor
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Methodology
CreditMetrics measures changes in portfolio value by predicting movements in a debtor's credit ratings and accordingly the values of individual portfolio investments.
After the values of the individual portfolio investments have been determined, CreditMetrics can then calculate the credit risk.
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CreditManager automatically maps each credit that the user loads into the system to its appropriate debtor and market data
It computes correlations and changes in asset value over the risk horizon due to upgrades, downgrades and defaults. In this way, it arrives at a final figure for portfolio credit risk. The software uses two types of data :
Position
Market
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That means calculating the value of Bond X for a credit rating of Aaa, Aa, A, Baa, Ba, B, Caa, Ca, C.
To do this, we first need to calculate the value of the bond's remaining cash flows for each possible rating.
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Given a distribution of final values for Bond X, we can then calculate two risk measurements for the portfolio:
Standard deviation Percentile
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Multiple-Credit Portfolios
Because of the exponential growth in complexity as the number of bonds increases, a simulation-based approach is used to calculate the distribution of values for large portfolios. Using Monte Carlo simulation, CreditMetrics simulates the quality of each debtor, which produces an overall value for the portfolio. This procedure is then repeated many times in order to get the distributed portfolio values. After we have the distributed portfolio values, we can then use the standard deviation and percentile levels for this distribution to calculate credit risk for the portfolio.
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Correlations
One key issue in using Credit Metrics is handling correlations between bonds.
While determining credit losses, credit rating changes for different counterparties cannot be assumed to be independent.
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Gausian Copula
A Gaussian Copula Model comes in useful here. Gaussian Copula allows us to construct a joint probability distribution of rating changes. The Copula correlation between the ratings transitions for two companies is typically set equal to the correlation between their equity returns using a factor model.
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