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The risk of traded instruments exists over the holding period only. The hold to maturity view does not hold because it is possible to get rid of the exposure whenever a warning light turns on. The view on credit risk for such an exposure is that it is the specific risk of value variations unrelated to market movements, as opposed to general risk driven by the market. This section contrasts traded instruments versus banking instruments and specific risk versus general risk. Over-the-counter derivatives do not trade, making it necessary to revert to the hold to maturity view, as explained when modelling their time profile of exposure.

Traded Instruments versus Banking Instruments

The loss for credit risk is the adverse change in price of securities due to credit events. It differs from the market risk loss, because the latter results from market movements while the loss from credit risk results only from credit events. Any credit risk event materializes into a price change. The issue is to define which components of price change are due to credit events. This necessitates a distinction between general and specific risk.

Specific and General Risk

In the market universe, risk materializes through adverse price changes. However, price changes result both from market movements and from specific issuer factors. General market movements in interest rate or equity index create general risk. General risk is the fraction of the asset return or of the price volatility related to market movements. By definition, it differs from credit risk, which is issuer-specific. Specific risk is the fraction of the price or return volatility unrelated to the market. It is, by definition, independent of market movements. The prevailing view is that specific risk is the credit risk or, equivalently, issuer risk.

Specific risk materializes differently for bonds or stocks. Holding bonds generates credit risk because the value of the bond changes with risk migrations. Drops in price materialize through a widening of the credit spread, the add-on to the risk-free rate used to get the risky discount rates for pricing the bond. Credit risk models for loans apply to bonds, and model the risk of change in value during a specified horizon due to credit risk migrations.

For stocks, the price embeds credit risk since it reflects any available information on the issuer. Hence, credit risk is the fraction of the price volatility of stocks unexplained by market indexes, or specific risk. Equity prices move down if the credit standing of the issuer deteriorates.

Market risk embeds specific risk since it captures all return variations, whether these are general or specific, over the liquidation period. Under this view, the issuer risk should already be in the market specific risk. However, when considering a holding period longer than the liquidation period, the market specific risk is no longer in line with the actual issuer risk. When dealing with credit risk, we look more at the issuer risk over a holding period than at specific market risk over a liquidation period. Therefore, we prefer to make a distinction between market specific risk and issuer credit risk.

When considering the holding period, specific risk becomes significant for stocks and bonds. The regulatory framework requires a forfeit value for credit risk, but accepts some recognition of the specific risk measures embedded in banks internal models. The January 1996 Basel Amendment to allow internal models of market risk stipulates the rules as follows:

there needs to be a prudential cushion to address the concern that practice is still developing in this area and that an industry consensus has not yet emerged about how best to model certain elements of specific risk. The Committee has accordingly decided to retain the treatment proposed in the April 1995 consultative document, whereby a modeled treatment of specific risk would be allowed subject to an overall floor on the specific risk charge equal to 50% of the specific risk charge applicable under the standardized approach. Banks whose models take little or no account of specific risk will be subject to the full specific risk charges of the standardized approach. For example, banks with models that are limited to capturing movements in equity indices, or to the spread between the inter-bank or corporate yield curves and that on government securities, should expect to receive the full specific risk charges of the standardized approach.