Quantifying Credit Correlation Risk

Gunter Meissner

“A key aspect of any credit risk VaR model is credit correlation”

– John Hull

In this chapter we will discuss and quantify the correlation risk of financial products whose primary focus is credit risk. Let us just clarify what credit risk is: credit risk is the risk of financial loss due to an adverse change in the credit quality of a debtor.

There are principally two types of credit risk: (a) migration risk; and (b) default risk. Figure 11.1 gives an overview of credit risk.

In Figure 11.1, migration risk refers to a migration from one credit state to another: for example, a downward migration from AAA to B. An upward migration from B to AAA can also hurt an investor, if they are short a bond or if the investor is paying fixed in a credit default swap (CDS); see Figure 11.2. Default risk is a special case of migration risk for a migration of the debtor into the default state. Default risk exists only for a long credit position: for example, being long a bond or long a tranche in a collateralised debt obligation (CDO).

Figure 11.1


However, migration risk and default risk have quite different dynamics. For instance, if a bond migrates to a lower state – say from B to CCC –

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