Credit BuVaR: Asymmetric spread VaR with default

Abstract

A tradeable credit instrument shows two forms of credit risk — a continuous spread risk and a discontinuous default risk. The Basel market risk framework requires the two risks to be modelled separately for the purpose of regulatory capital but this gives rise to issues of risk aggregation. The author proposes a risk metric called credit bubble VaR (Cr. buVaR) that combines these dual risks under a common historical simulation value-at-risk (VaR) approach. By using a single model, Cr. buVaR bypasses the problem of risk aggregation. Credit risks can then be aggregated with market risk in a diversifiable manner. Cr. buVaR is also found to be forward-looking with respect to issuer credit default and is not procyclical. The model is motivated by evidence from the 2008 crisis that issuer defaults and spread movements exhibit asymmetry, and that defaults are always preceded by rapid spread widening. The method involves scaling the positive side of the return distribution of credit spreads in proportion to current spread levels. By drawing inferences from studies on the ‘credit spread puzzle’, it is deduced that the incremental loss of Cr. buVaR over spread VaR is due to default risk.