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Since modeling leaves complete freedom we can assume both market and credit risks can enter the picture. However the minimum requirement is (migrations and) defaults simulation, how does this configure as "pure" market risk (especially in the latter IDRC case), as various people claim?

Why would CVA be more credit-related than IRC? After all CVA is about prices and IRC about exposures and defaults (yeah, of course this is incorrect, but let's play the devil's advocate), even though they are both motivated by adverse market moves. (Atleast Brigo calls them both credit risks iirc.) Is it simply because of spreads simulation? Or because we're patching a market risk measure? Or is there a more sound reason? And why isnt IRC just a liquidity-enhanced credit VaR?

I've been given very odd and contradictory answers, and wont state here my understanding of the issue to avoid introducing more confusion and hoping to hear a clear definition of the two risks. Which is not so easy given the blurring boundary.

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  • $\begingroup$ I am not that into banking regulations: could you please spell out some of the acronyms ? Thanks! $\endgroup$ – Ric Feb 12 '16 at 8:53
  • $\begingroup$ Incremental (Default) Risk Charge (now morphed again as DRC iirc), and Credit Valuation Adjustment. $\endgroup$ – Quartz Feb 12 '16 at 16:51
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You find the IRC methodology paper written by Tim Xiao at

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2426836

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    $\begingroup$ Hi Dora, welcome to quant stack exchange. Can you provide the salient points from the paper that answers the OP's question? $\endgroup$ – AfterWorkGuinness Oct 15 '15 at 2:53
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    $\begingroup$ This is not really an answer. $\endgroup$ – Gordon Jan 13 '16 at 18:21
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Reading EBA:s draft guidelines on IRC from 2011, the following quote points at it beeing entirely in the credit risk domain: "20.3 If a simulation, e.g. the asset value process, has not resulted in a changed rating, no change in value shall be assumed..." No change in credit standing, no change in rating and no change in IRC, so IRC is fully credit related.

Furthermore, in 20.4, regarding migration events, there is no word of incorporating changes in market prices of risk in the calculation, instead a preset rating-to-spread table should be used: "The impact of a rating migration on market prices may be estimated using either currently observed market data (e.g. spreads); or an average of historical market data observed...".

So I would humbly say that in the EBA draft of 2011 we have a pure credit model, and market prices are only in it as a misleading name for how rating changes are mapped on economic impact in the model.

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