CVaR and Credit Risk Measurement

Abstract: The link between credit risk and the current financial crisis accentuates the importance of measuring and predicting extreme credit risk. Conditional Value at Risk (CVaR) is a method used widely in the insurance industry to measure extreme risk, and has also gained popularity as a measure of extreme market risk. We combine the CVaR market approach with the Merton / KMV credit model to generate a model measuring credit risk under extreme market conditions. The Merton / KMV model is a popular model used by Banks to predict probability of default (PD) of customers based on movements in the market value of assets. The model uses option pricing methodology to estimate distance to default (DD) based on movements in the market value of assets. This model has been popularized among Banks for measuring credit risk by KMV who use the DD approach of Merton but apply their extensive default data base to modify PD outcomes. Our extreme credit model is used to compare default risk among sectors in an Australian setting. An in depth understanding of sectoral risk is vital to Banks to ensure that there is not an overconcentration of credit risk in any sector. This paper demonstrates how CVaR methodology can be applied to credit risk in different economic circumstances and provides Australian Banks with important insights into extreme sectoral credi