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Information Management Network

 
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CreditMetrics-DOs and DON'Ts

When RiskMetrics came out in 1994, many people seized on the idea as a general panacea for all their risk problems. Managers rushed to make sure they could run RiskMetrics-style Value-at-Risk-sometimes before they identified whether Morgan's covariance methodology was really appropriate for their portfolios. Software vendors rushed to have "RiskMetrics compatible" products.

Now that CreditMetrics is on the scene, two questions arise: How can I implement CreditMetrics effectively? And, What can-and can't-CreditMetrics and CreditManager, Morgan's CreditMetrics software program, realistically do for me? (For a description of the CreditMetrics methodology, see "JP Morgan Tackles Credit Risk," May.)

Do...

  • Carefully review the CreditMetrics methodology.

    CreditMetrics is much more complex than RiskMetrics, and therefore demands a careful review. Indeed, within the CreditMetrics framework, users are faced with a variety of choices. For example, CreditMetrics allows users to adopt one of four different approaches to estimating correlation among various credit types-historical data, bond spreads, equity correlations or uniform constants.

    There are pros and cons to each method. The method using historical rating and default data represents real events, but, because credit events are rare, this data is sparse and uneven. Bond spreads are readily available for some securities, but they are not a pure reflection of the market's opinion on the underlying credit. Equity prices are liquid and provide market information, but they may not be as useful in illiquid and private markets. The uniform constant is extremely easy to implement-and is reasonably accurate in the case of a well-diversified portfolio-but it certainly does not capture the entire picture. Choose carefully because your decision could have a big effect on the outcome.

  • Decide whether CreditMetrics is right for you.

    According to Mac McQuown, a vice president at San Francisco-based KMV, CreditMetrics is a quality credit-risk-measurement tool, but it does include certain simplifications. For example, he explains that using commercially available credit ratings, such as Moody's and S&P ratings, to evaluate credit quality can be imprecise. Instead, he explains, some financial institutions may wish to create more customized credit risk weights-as well as their own proprietary "transition matrices" for determining the probability that these credit weights may fluctuate. Although CreditMetrics is flexible enough to handle proprietary credit ratings, a highly intricate setup might be better handled through a more complex methodology.

  • Use CreditMetrics as an education tool.

    According to Blythe Masters, one of the principal architects of CreditMetrics, one of the goals behind the product's release is to raise the level of dialogue on the topic of credit risk management. Even if CreditMetrics is not a perfect fit with your operations, the well-documented methodology is an excellent guided tour of quantitative credit risk management and thus an appropriate training tool.

  • Consider getting CreditManager.

    Credit risk measurement is widely recognized to be much more difficult than market risk measurement. At $10,000 to install and $25,000 for annual maintenance, most software experts we contacted rate the CreditManager-assuming its functionality even comes close to the hype-as a steal.

Don't...

  • Don't add CreditMetrics and RiskMetrics numbers together.

    CreditMetrics generates a Value-at-Risk for credit risk and RiskMetrics generates a Value-at-Risk for market risk. So, you might think, wouldn't adding the numbers together give you a total risk measurement for both your market and credit risk? Not necessarily. Because there are correlations between market movements and changes in credit exposure, the sum of a purely market-based Value-at-Risk and a pure credit Value-at-Risk could substantially overstate-or understate-your risk, depending upon whether your credit and market exposures are positively or negatively correlated.

  • Don't confuse the Credit Exposure Calculator in FourFifteen with the CreditManager.

    In order to help clients calculate the counterparty exposure associated with "market"-based instruments such as interest rate swaps, foreign exchange forwards and so on, JP Morgan has built a credit exposure calculator into its FourFifteen product, which allows users to retrieve this credit exposure from their market-based instruments. This credit exposure can then be lugged into a CreditMetrics calculation. But the two are not the same.

  • Don't wait for JP Morgan to integrate market and credit risk.

    For some institutions, it is critical to begin integrating credit and market risk management as quickly as possible. While CreditMetrics-as a companion to RiskMetrics-is a considerable step toward creating an integrated framework for both credit and market risk management, it may be quite some time before total integration is complete. According to Ron Dembo, founder of Algorithmics, a risk management software and research and development firm, a risk management methodology must have grounding in solid financial theory if it is to be easily extensible. He suggests that the reason why JP Morgan-and other purveyors of risk measurement methodologies-may have some difficulty creating a combined credit and market risk measure is that they have addressed both credit and market in an ad hoc fashion, rather than as components of a larger, more holistic theory.

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