Hello, Can anyone help explain Credit VAR to me? (pg230/reading 40). I understand VAR in general very well, and my sense is that this is not supposed to be a difficult concept, but for some reason it’s not yet clicked. Why for example are you focusing on the upper tail instead of the lower tail and how do the inputs and interpretation differ from regular VAR? Any tips are appreciated. Thanks
The reason you focus on the upper tail is because the higher the value of the asset, the more value at risk. In the case of the lower tail or negative returns you do not face any credit risk and so credit VAR.
Assume you bought lots of S&P Calls in 2009. Now it is 2011 and economy is booming. You are going to earn tons of money but wait!! The short was Lehman and now he is no more, RIP. So suddenly, you’re not gonna earn any money. Poof! Now think of the payoffs pattern of calls. They’ll form a probability curve. Your ‘Potential Credit Loss’ start in the upper tail when you’re in the money. (Upper tail = more payoff) That’s how i think of it OA.
in the schweser note, they gave a pretty good explanation usi MBS as example. dont have book w/ me, but I remember if interest rate goes down, MBS value will increase. if you’re a MBS holder, you’re supposed to be happy. However, when interest rate go down, ppl will refinance, so the gain is actually accrued to the issuer, thus upper tail risk.
here a more recent thread: https://www.analystforum.com/forums/cfa-forums/cfa-level-iii-forum/91339687#comment-91819557
I suspect that someone who was a Level III candidate 9 years ago couldn’t care less about a more recent thread.