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Risk Management and Financial Institutions, + Web Site, 3rd Edition by John C. Hull

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CHAPTER 18

Credit Value at Risk

Value at risk is central to the determination of regulatory capital and to much of the risk management carried out by both financial and nonfinancial corporations. Chapters 14 and 15 discussed the calculation of market risk VaR. This chapter covers credit risk VaR.

Credit risk VaR is defined similarly to market risk VaR. It is the credit risk loss over a certain time period that will not be exceeded with a certain confidence level. Some credit risk VaR models consider only losses from defaults; others consider losses from downgrades and credit spread changes as well as from defaults.

Banks calculate credit risk VaR to determine both regulatory capital and economic capital. The regulatory capital requirements for credit risk were discussed in Chapters 12 and 13. Economic capital, which will be discussed in Chapter 23, is a financial institution’s own estimate of the capital it requires for the risks it is taking and is used to calculate return on capital measures for its business units. Sometimes the VaR model that a bank chooses to use to determine credit risk economic capital is different from the one it is required to use for the determination of regulatory capital.

In Chapter 16, we explained the important difference between risk-neutral and real-world default probabilities. Risk-neutral default probabilities are used for estimating the present value of future credit losses. The procedure is to estimate expected losses in a risk-neutral world ...

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