Bubble Value at Risk: A Countercyclical Risk Management Approach, Revised Edition

Chapter 14

Credit BuVaR

The basic buVaR idea cannot be used in the credit world because trends and cycles are not well behaved. Credit spreads often trade in a range during times of normalcy, determined by an issuer’s cost of funds and ratings. Then, upon credit stress, the spreads break out and become mean-fleeing. This rare breakout behavior throws off the buVaR’s bubble measure. Fortunately, with a modification to the buVaR framework, its usage can be extended to the credit world with interesting outcomes.

14.1 THE CREDIT BUBBLE VaR IDEA

Conventional credit spread value at risk (VaR) that uses historical simulation already captures the risk of (continuous) spread movements. On the other hand, the default risk (a discontinuous jump risk) is separately modeled using default migration models such as CreditMetrics, which use rating migration transition matrix and actual default statistics of companies collected by rating agencies. But, the historically recorded default rates can be a misleading indicator of future default risk because they are procyclical and backward-looking, and they critically lag actual defaults.

For example, during the precrisis golden decade (1998–2006) the default statistics were very low and would underestimate the true default probability realized during the 2007–2008 credit crunch when credit quality rapidly deteriorated. And surely the default rates recorded during the credit crunch period would grossly overstate the future default probability after the ...