Credit Spreads

Raquel Bujalance and Oliver Burnage

ALM risk management has traditionally focused on management of the interest rate risk, but standards for interest rate risk in the banking book (IRRBB) published in 2016 by the Basel Committee on Banking Supervision (BCBS) includes credit spread risk as another piece of the puzzle, as changes in the credit spreads could amplify the risk already arising from the IRRBB.

Incorporating the credit risk factor in the calculation of market value of equity (MVE) is often very complex and challenging. First, it is necessary to consider whether it is more appropriate to model this risk through a future cashflow estimation (assuming a probability of default and recovery) or through a credit spread. As we shall show in this chapter, this decision could affect some metrics, such as the duration of the portfolio, in different ways. Second, the challenge is to build the spread curves (or, if a probability of default (PD) and a recovery is needed, how to calibrate them), and to determine the relationship between these parameters and those used for other purposes within the bank: the credit risk area might estimate different PDs for different purposes, while the counterparty risk area might

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