“Unlike the VAR we associate with negative returns on assets (left tail), the credit manager must focus on the upper tail (right tail) of possible returns. An increase in the value of (a positive return on) these assets, for example, accrues to the debtor in the form of the option to refinance.” I understand why we need to look at the right side of the distribution. If we have an forward and we have a big gain on it then we have a lot of credit risk (conversely if we have a loss then the other side has the credit risk). I don’t think I fully understand the second sentence in the quote above though. Can someone elaborate? This from schweser, reading 40 p 187
I think what they (Schweser?) is trying to get it as that you can’t seperate credit VAR from market VAR because the instruments are still subject to market risks, thus making credit VAR extremely hard to calculate as opposed to market VAR.
Here is my understanding. VAR is value-at-risk, the max credit loss for a given confidence interval over a given time period. This form of VAR generally applies to a portfolio or a firm - for example you might have a daily VAR of $1,000,000 with a 95% confidence interval. That would tell you your daily loss will exceed $1,000,000 only 5% of the time. For Credit VAR, we are talking about contracts, ie forwards, swaps, and options. In these contracts, there is not only concern for the “lower tail” of returns, but also the embedded option that the debtor has to refinance their loan given favorable terms. So say with the simple example of a mortgage-backed security, interest rates go down, so the value of the security increases. However, the debtor refinances on more favorable terms, so you: the lender lose out on that positive move. The point is that we can think about these contracts in terms of VAR but also must recognize that VAR is only a part of the story and other factors must be considered.
Okay, you kind of lost me Dwight. See below: Dwight Wrote: ------------------------------------------------------- > Here is my understanding. > > VAR is value-at-risk, the max credit loss for a > given confidence interval over a given time > period. This form of VAR generally applies to a > portfolio or a firm - for example you might have a > daily VAR of $1,000,000 with a 95% confidence > interval. That would tell you your daily loss > will exceed $1,000,000 only 5% of the time. I understand this (although I might take exception with the term credit loss). > > For Credit VAR, we are talking about contracts, ie > forwards, swaps, and options. In these contracts, > there is not only concern for the “lower tail” of > returns, but also the embedded option that the > debtor has to refinance their loan given favorable > terms. Do you mean lower tail concern for VAR here? It is my understanding that in order to have credit risk (current or future), you have to have a postive return on the contract, which is why Credit VAR is concerned with the right tail of the distribution. > > So say with the simple example of a > mortgage-backed security, interest rates go down, > so the value of the security increases. However, > the debtor refinances on more favorable terms, so > you: the lender lose out on that positive move. This is where I get lost. This is simliar to an example is the prof note in schweser. I don’t see what this has to due with credit risk here. I can see if we are talking about a plain vanilla bond and the underlying company is in trouble that our credit risk increases. But in the example above the underlying mortgage holders don’t have to pay anymore on their mortgage, so if anything when rates drop and refinancing becomes attractive there should be less credit risk. > > The point is that we can think about these > contracts in terms of VAR but also must recognize > that VAR is only a part of the story and other > factors must be considered. I get this…I just can’t see the whole picture yet. I am sure I am missing something really basic here.
I’ve figured out where you are getting stuck. You are only equating credit risk with default risk. The actual definition of credit risk is “The risk of loss of principal or loss of a financial reward stemming from a borrower’s failure to repay a loan or otherwise meet a contractual obligation” So int he above we are dealing with the loss of reward and not the underling health of the of the borrower.
mwvt9 Wrote: ------------------------------------------------------- > “Unlike the VAR we associate with negative returns > on assets (left tail), the credit manager must > focus on the upper tail (right tail) of possible > returns. An increase in the value of (a positive > return on) these assets, for example, accrues to > the debtor in the form of the option to > refinance.” mwvt, you are definitely getting the big picture. Your unrealized gains can’t be realized because the counter party defaults on their obligation to you. I’m not quite sure about the example used in Schweser. I guess you want to excercize your option to refinance, but the other party doesn’t honor it. For example, you got mortgage at 6.5% and want to refinance at 5% but the lender doesn’t let you do that. That might be a lame interpretation but that’s the best I can do.
budfox427 Wrote: ------------------------------------------------------- > I’ve figured out where you are getting stuck. You > are only equating credit risk with default risk. > > > The actual definition of credit risk is “The risk > of loss of principal or loss of a financial reward > stemming from a borrower’s failure to repay a loan > or otherwise meet a contractual obligation” > > So int he above we are dealing with the loss of > reward and not the underling health of the of the > borrower. You nailed it. Thanks bud.
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.
I didn’t have in mind the guy who started the thread but rather the new people who are browsing his forum and are finding a dozen of threads on the very same topic 