Portfolio Credit Risk

This paper describes a new and intuitive methodfor answering these technical questions by tabulating theexact loss distribution arising from correlated credit eventsfor any arbitrary portfolio of counterparty exposures, downto the individual contract level, with the losses measuredon a marked-to-market basis that explicitly recognises thepotential impact of defaults and credit migrations.1 Theimportance of tabulating the exact loss distribution ishighlighted by the fact that counterparty defaults and ratingmigrations cannot be predicted with perfect foresightand are not perfectly correlated, implying that managementfaces a distribution of potential losses rather than asingle potential loss. In order to define credit risk moreprecisely in the context of loss distributions, the financialindustry is converging on risk measures that summarise management-relevant aspects of the entire loss distribution. Two distributional statistics are becoming increasinglyrelevant for measuring credit risk: expected lossesand a critical value of the loss distribution, often defined asthe portfolio’s credit risk capital (CRC). Each of theseserves a distinct and useful role in supporting managementdecision making and control (Exhibit 1).[...]