regarding spread risk in CreditMetric model

[laura1987]

Hi,
I came across a question abt using CreditMetric model. The question mentioned that :"In computing firm-wide risk using the distribution of its loand portfolio, the bank is most likely to understate its risk because it ignores:..."

Among several options, the answer is " Ignore spread risk". I did not really get that point. Why it can say the credit spreads for verious cerdit ratings are assumed to remain constant while CreditMetric apply different yield curve for different credit rating?

Thank for any help from you all.

Laura.

 

[David Harper CFA FRM]

Laura,

I think you have a good point b/c it seems to turn on the definition of "spread risk" and the CM does exhibit spreads by way of different term structures for each rating. This question comes straight from de Servigny, where he cites PRT as the only credit risk model that accounts for spread risk, in addition to default and migration (a.k.a., deterioration due to downgrade). So the point is: CM captures risk via upgrade/downgrade (migration) and default too (as a special case of migration) but does not explicitly model (i.e., incorporate as a risk factor) spread volatility, which is an interaction of market and credit risk; i.e., the risk the spread will (stochastically) widen, not necessarily due to credit deterioration, but just because of market based factors (liquidity, demand). Put another way, CM does not have a factor for spread widening that is not due to credit-specific downgrade.

David

 

[laura1987]

Thank David for your answer. May I know what PRT stand for?

 

[David Harper CFA FRM]

Portfolio Risk Tracker (PRT) is among the de Servigny credit models (however, I cannot recall a question being asked about it. Low testability) - David