Appendix 12A1 CreditMetrics

CreditMetrics was introduced in 1997 by JPMor- Consider the example of a five-year, fixed-rate
gan and its co-sponsors (Bank of America, Union loan of $100 million made at 6 percent annual
Bank of Switzerland, et al.) as a value at risk (VaR) interest.4 The borrower is rated BBB.
framework to apply to the valuation and risk of
non-tradable assets such as loans and privately RATING MIGRATION
placed bonds.2 Thus, while RiskMetrics seeks to
On the basis of historical data collected by S&P,
answer the question, if tomorrow is a bad day,
Moody’s, and other bond analysts, it is estimated
how much will I lose on tradable assets such as
that the probability of a BBB borrower’s staying
stocks, bonds, and equities? CreditMetrics asks, if
at BBB over the next year is 86.93 percent. There
next year is a bad year, how much will I lose on
is also some probability that the borrower of the
my loans and loan portfolio?3
loan will be upgraded (e.g., to A), and there is
With RiskMetrics (see Chapter 10) we answer
some probability that it will be downgraded (e.g.,
this question by looking at the market value or
to CCC) or even default. Indeed, there are eight
price of an asset and the volatility of that asset’s
possible transitions the borrower can make over
price or return in order to calculate a probability
the next year, seven of which involve upgrades,
(e.g., 5 percent) that the value of that asset will
downgrades, and no rating changes and one that
fall below some given value tomorrow. In the
involves default. The estimated probabilities are
case of RiskMetrics, this involves multiplying the
shown in Table 12A–1.
estimated standard deviation of returns on that
asset by 1.65 and then revaluing the current mar-
ket value of the position (P) downward by 1.65␴. VALUATION
That is, daily value at risk (daily VaR at a 95 per- The effect of rating upgrades and downgrades
cent confidence level) is is to impact the required credit risk spreads or
VaR 5 P 3 1.65 3 ␴ premiums on loans and thus the implied market
value (or present value) of the loan. If a loan is
Unfortunately, since loans are not publicly
traded, we observe neither P (the loan’s market TABLE 12A–1 One-Year Transition Probabilities
value) nor ␴ (the volatility of loan value over the for BBB-Rated Borrower
horizon of interest—assumed to be one year for Transition
loans and bonds under CreditMetrics). However, Rating Probability
using (1) available data on a borrower’s credit AAA 0.02%
rating, (2) the probability of that rating changing AA 0.33
over the next year (the rating transition matrix), A 5.95
(3) recovery rates on defaulted loans, and (4) yield BBB 86.93 Most likely to stay
spreads in the bond market, it is possible to cal- in same class
culate a hypothetical P and ␴ for any non-traded BB 5.30
loan or bond and thus a VaR figure for individual B 1.17
loans and the loan portfolio. CCC 0.12
Default 0.18

1
This appendix, which contains more technical topics, may be included in or dropped from the chapter reading depending on the rigour of the course.
2
See JPMorgan, CreditMetrics—Technical Document, New York, April 2, 1997; and A. Saunders and L. Allen, Credit Risk Measurement: New Approaches
to Value at Risk and Other Paradigms, 2nd ed. New York: John Wiley & Sons, 2002, Chapter 6.
3
In 2002, JPMorgan introduced a third measure of credit risk, CreditGrades. The CreditGrades model establishes a framework linking the credit and
equity markets. The model employs approximations for the asset value, volatility, and drift, which are used to value credit as an exotic equity derivative.
This model is similar in approach to the KMV model described in the chapter. See CreditGrades: Technical Documents, RiskMetrics Group, Inc., May 2002.
4
This example is based on the one used in JPMorgan, CreditMetrics—Technical Document, April 2, 1997.

12A-1
12A-2 Appendix 12A CreditMetrics

downgraded, the required credit spread premium
should rise (remember, the loan rate in our exam-
ple is fixed at 6 percent) so that the present value
of the loan to the FI should fall; the reverse is true
for a credit rating upgrade.
Technically, since we are revaluing the five-
year $100 million, 6 percent loan at the end of the
first year after a credit event has occurred during
that year, then (measured in millions of dollars):
6 6
P561 1
11 1 r1 1 s1 2 11 1 r2 1 s2 2 2
6 106
1 1
11 1 r3 1 s3 2 3 11 1 r4 1 s4 2 4
where the ri are the risk-free rates on T-bonds
expected to exist one year, two years, and so on,
into the future (i.e., they reflect forward rates from
the current Treasury yield curve—see discussion
in Chapter 11—and si are annual credit spreads
for loans of a particular rating class of one year,
two years, three years, and four years to maturity
(the latter are derived from observed spreads in
the corporate bond market over Treasuries). Sup-
pose the borrower is upgraded during the first
year from BBB to A. Table 12A–2 shows the hypo-
thetical values of rt and st over the four years.
That is, at the end of the first year, if the loan
borrower is upgraded from BBB to A, the $100 mil-
lion (book value) loan has a market value to the FI
of $108.66 million. (This is the value the FI would
theoretically be able to obtain if it “sold” the loan,
with the accrued first year coupon of 6, to another
FI at the end of year 1 horizon at the fair market
price or value.) Table 12A–3 shows the value of
the loan if other credit events occur. Note that the
loan has a maximum market value of $109.37 (if
the borrower is upgraded to AAA) and a mini-
mum value of $51.13 if the borrower defaults. The
minimum value is the estimated recovery value of
the loan if the borrower declares bankruptcy.
TABLE 12A–3 Value of the Loan at the End of One
Year under Different Ratings
Year-End Loan Value ($) (including
Rating first-year coupon)
AAA 109.37
AA 109.19
A 108.66
BBB 107.55
BB 102.02
B 98.10
CCC 83.64
Default 51.13

TABLE 12A–2 Risk-Free Rates on T-Bonds and The probability distribution of loan values is
Annual Credit Spreads
shown in Figure 12A–1. As can be seen, the value
Year rt st
1 3.00% 0.72% FIGURE 12A–1 Distribution of Loan Values on
a Five-Year BBB Loan at the End
2 3.57 0.75
of Year 1
3 4.05 0.88
Probability
4 4.40 0.92

The first coupon or interest payment of $6 mil-

lion in the above example is undiscounted and can
be viewed as being similar to the accrued interest
earned on a bond or a loan since we are revaluing
the loan at the end (not the beginning) of the first
year of its life. Then the present value or market
value of the loan to the FI at the end of the one-
year risk horizon (in millions of dollars) is:

6 6 6 106
P561 1 1 1
11.0372 2 11.0432 2 2
11.0493 2 3
11.0532 2 4 Value of loan
51.13 107.09 109.37
5 $108.66 = Mean
 Appendix 12A CreditMetrics 12A-3

of the loan has a fixed upside and a long downside
(i.e., a negative skew). It is clear that the value of the
loan is not symmetrically (or normally) distributed.
Thus CreditMetrics produces two VaR measures:
1. Based on the normal distribution of loan values.
2. Based on the actual distribution of loan values.
CALCULATION OF VaR
Table 12A–4 shows the calculation of the VaR
based on each approach for both the 5 percent
worst-case and the 1 percent worst-case scenarios.
The first step in calculating VaR is to calculate
the mean of the loan’s value, or its expected value,
at year 1, which is the sum of each possible loan
value at the end of year 1 times its transition prob-
ability. As can be seen, the mean value of the loan
is $107.09 (also see Figure 12A–1). However, the
FI is concerned about losses or volatility in value.
In particular, if next year is a bad year, how much
can it expect to lose? We could define a bad year as
occurring once every 20 years (the 5 percent VaR)
or once every 100 years (the 1 percent VaR)—this
is similar to market risk VaR except that for credit
risk the horizon is longer: 1 year rather than 1 day.
Assuming that loan values are normally dis-
tributed, the variance of loan value around its
mean is $8.9477 (squared) and its standard devia-
tion or volatility is the square root of the variance
equal to $2.99. Thus the 5 percent VaR for the loan
is 1.65 ⫻ $2.99 = $4.93 million, while the 1 percent
VaR is 2.33 ⫻ $2.99 = $6.97 million. However, this
is likely to underestimate the actual or true VaR
of the loan because, as shown in Figure 12A–1,
the distribution of the loan’s value is clearly non-
normal. In particular, it demonstrates a negative
skew or a long-tail downside risk. Using the actual
distribution of loan values and probabilities,
we can see from Table 12A–4 that there is a 6.77
percent probability that the loan value will fall
below $102.02, implying an approximate 5 percent
actual VaR of over $107.09 − $102.02 = $5.07 mil-
lion, and that there is a 1.47 percent prob-
ability that the loan value will fall below $98.10,
implying an approximate 1 percent actual VaR of
over $107.09 − $98.10 = $8.99. These actual VaRs
could be made less approximate by using lin-
ear interpolation to get the exact 5 percent and
1 percent VaR measures. For example, since the
1.47 percentile equals 98.10 and the 0.3 percentile
equals 83.64, then, using linear interpolation, the

TABLE 12A–4 VaR Calculations for the BBB Loan

Probability New Loan Value Probability Difference of Probability

Year-End of State plus Coupon Weighted Value Value from Mean Weighted
Rating (%) ($) ($) ($) Difference Squared
AAA 0.02% $109.37 $ 0.02 $2.28 0.0010
AA 0.33 109.19 0.36 2.10 0.0146
A 5.95 108.66 6.47 1.57 0.1474
BBB 86.93 107.55 93.49 0.46 0.1853
BB 5.30 102.02 5.41 (5.06) 1.3592
B 1.17 98.10 1.15 (8.99) 0.9446
CCC 0.12 83.64 1.10 (23.45) 0.6598
Default 0.18 51.13 0.09 (55.96) 5.6358
Mean = $107.09 Variance = 8.94777

␴ = Standard deviation = $2.99

Assuming Normal 5% VaR 5 1.65 3 ␴ 5 $4.93
b
Distribution 1% VaR 5 2.33 3 ␴ 5 $6.97
Assuming Actual 5% VaR 5 95% of actual distribution 5 $107.09 2 $102.02 5 $5.07
b
Distribution* 1% VaR 5 99% of actual distribution 5 $107.09 2 $98.10 5 $8.99

*5% VaR approximated by 6.77% VaR (i.e., 5.3% + 1.17% + 0.12% + 0.18%) and 1% VaR approximated by 1.47% VaR (i.e., 1.17% + 0.12% + 0.18%).
12A-4 Appendix 12A CreditMetrics

1.00 percentile equals $92.29. This suggests an VaR measures developed above. Using the 1 per-
actual 1 percent VaR of $107.09 − $92.29 = $14.80. cent VaR based on the normal distribution, a capi-
tal requirement of $6.97 million would be required
CAPITAL REQUIREMENTS (i.e., less than OSFI’s requirement), while using
the 1 percent VaR based on the iterated value from
It is interesting to compare these VaR figures
the actual distribution, a $14.80 million capital
with the capital reserves against loans currently
requirement would be required (which is much
required by OSFI. As discussed in Chapter 20,
greater than OSFI’s capital requirement).
depending on the approach adopted under Basel II,
It should be noted that under the CreditMet-
each loan held by a Canadian bank may carry an
rics approach, every loan is likely to have a dif-
individual capital requirement based on its credit
ferent VaR and thus a different implied capital
rating. In our example of a $100 million face (book)
requirement.
value BBB loan, the capital requirement would be
$8 million. This contrasts to the two market-based

Questions and Problems

1. From Table 12A–1, what is the probability of a loan
upgrade? A loan downgrade?
a. What is the impact of a rating upgrade or
downgrade?
b. How is the discount rate determined after a
credit event has occurred?
c. Why does the probability distribution of pos-
sible loan values have a negative skew?
d. How do the capital requirements of the Credit-
Metrics approach differ from those of OSFI?
2. A five-year fixed-rate loan of $100 million carries
a 7 percent annual interest rate. The borrower is
rated BB. Based on hypothetical historical data, the
probability distribution given in the table below
has been determined for various ratings upgrades,
downgrades, status quo, and default possibilities
over the next year. Information also is presented
reflecting the forward rates of the current Treasury
yield curve and the annual credit spreads of the
various maturities of BBB bonds over Treasuries.
a. What is the present value of the loan at the end of
the one-year risk horizon for the case where the
borrower has been upgraded from BB to BBB?
b. What is the mean (expected) value of the loan at
the end of year 1?
c. What is the volatility of the loan value at the
end of year 1?
d. Calculate the 5 percent and 1 percent VaRs for
this loan, assuming a normal distribution of
values.
e. Estimate the approximate 5 percent and 1 per-
cent VaRs using the actual distribution of loan
values and probabilities.
f. How do the capital requirements of the 1 per-
cent VaRs calculated in parts (d) and (e) above
compare with the capital requirements of OSFI?

Forward Rate Spreads at Time t

Probability New Loan Value
Rating Distribution plus Coupon $ t rt% st%
AAA 0.01% $114.82 1 3.00% 0.72%
AA 0.31 114.60 2 3.40 0.96
A 1.45 114.03 3 3.75 1.16
BBB 6.05 4 4.00 1.30
BB 85.48 108.55
B 5.60 98.43
CCC 0.90 86.82
Default 0.20 54.12