Business — Banking — Management — Marketing & Sales

The basic economic measures of risk are the Expected Loss (EL), the standalone Loss Volatility (LV) and the Value at Risk (VaR). The EL serves for economic provisioning, and for statistical loss management, while the LV captures the dispersion of losses around the mean and relates to the unexpected loss concept. VaR measures define capital and are the loss percentile L(a) at various confidence levels a. The determination of the value, or loss, distribution of a transaction at a future horizon is a prerequisite for obtaining such measures. This chapter addresses standalone risk for a single transaction only.

Under default mode only (without valuation of risk migrations), a single banking exposure generates a binary standalone loss distribution with two events: default or no default. When considering the time profile of default risk, the distribution of the future values of a single exposure extends because loss values, as of today, depend on marginal probabilities of default and on discount factors that vary across future dates.

Under full valuation of migrations, there are as many values at the horizon as there are migrations according to the matrix valuation technique. Credit spreads in conjunction with the distribution of final credit states provide the distribution of values at the horizon.

For market exposures, the issue is different because the hold to maturity view collapses for traded instruments. Credit risk is specific risk, or the fraction of the volatility of the value of market instruments unrelated to general market movements. For over-the-counter derivatives, exposures require modelling. Common practices use loan equivalents summarizing the time profiles of derivative exposures and treat them like banking exposures. Loan equivalents should be based on modelled potential exposures (Chapter 39).

The first section discusses loss distributions for a single banking exposure. The second section discusses full migration matrix valuation based on market credit spreads, which assigns values according to the final state post-migration. The third section discusses market instruments and the rationale for using specific risk for traded assets and modelled exposures for over-the-counter derivatives.