Credit Risk vs Market Risk

The tools recently developed to measure market risk have proved invaluable to assess credit risk. Even so, there are a number of major differences between market and credit risks, which are listed in Table 18-1.

TABLE 18-1 Comparison of Market Risk and Credit Risk

Market

Credit

Item

Risk

Risk

Sources of risk

Market risk only

Default risk,

recovery risk,

market risk

Distributions

Mainly symmetric,

Skewed to the left

perhaps fat tails

Time horizon

Short term (days)

Long term (years)

Aggregation

Business/trading unit

Whole firm vs.

counterparty

Legal issues

Not applicable

Very important

As mentioned previously, credit risk results from a compound process with three sources of risk. The nature of this risk creates a distribution that is strongly skewed to the left, unlike most market risk factors. This is because credit risk is akin to short positions in options. At best, the counterparty makes the required payment and there is no loss. At worst, the entire amount due is lost.

The time horizon is also different. Whereas the time required for corrective action is relatively short in the case of market risk, it is much longer for credit risk. Positions also turn over much more slowly for credit risk than for market risk, although the advent of credit derivatives now makes it easier to hedge credit risk.

Finally, the level of aggregation is different. Limits on market risk may apply at the level of a trading desk, business units, and eventually the whole firm. In contrast, limits on credit risk must be defined at the counterparty level, for all positions taken by the institution.

Credit risk can also mix with market risk. Movements in corporate bond prices indeed reflect changing expectations of credit losses. In this case, it is not so clear whether this volatility should be classified into market risk or credit risk.

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