Can someone explain this to me? (Market VAR, Credit VAR)

CFA Level III Derivatives
#1
  • Market VAR – left tail risk because returns are low
  • Credit VAR – right tail risk because credit risk is highest when returns and market value are highest

Shouldn’t market VAR also be in right tail i.e. when market value is highest?

#2

when you are looking at your portfolio - you are focusing on losses on your portfolio itself when you are looking at VAR. So it is left tail risk. (You want to calculate where your portfolio falls below a certain value).

Now flip it around. You own something on your portfolio - which is shady credit. e.g. and you want to calculate / assign a VAR value to when it will be the highest loss for you. When will that be - when it is at its highest value.That is when you (the investor in that shady credit deal) will lose the most. So that is right tail. The higher that value is, the more YOU will lose.

#3

So when looking at VAR, I was still thinking along similar lines. When I am looking at right tail, shouldn’t it be the case where my portfolio will have highest value and possiblity to lose more value according to VAR?

#4

Sachin - may be think in terms of Estimated Loss and Potential Loss. When you are calculating market VAR, you are looking at what is the maximum estimated loss (Value at Risk) that can occur. Note that market VAR is not the actual loss…so we are focusing on how much we can lose x% in y time.

Now on the credit side, if you are looking at the left tail, it means you owe to the counterparty in which case you do not have the risk, but the counterparty has the risk that you won’t pay. Alternatively, you will have risk when the counterparty owes you (Right tail). Again, this is not the actual loss, but the potential loss that can occur.

Hope that makes sense.

#5

VAR is the minimum expected loss at a given probablity, not the maximum.

#6

Market VAR comes into play when returns are negative and you’re concerned that you’ll lose money in your portfolio.

Losing money when returns are negative is left-tail.

Credit VAR comes into play when someone owes you money and you’re concerned that they won’t pay you.

Someone owing you is right-tail.

#7

Thanks Galli for correcting.

#8

Thank you all… I have it clear now.

#9

Good to know.

My pleasure.

#10

Credit Risk pertains fixed income instruments and derivatives, i.e. instruments where payments/obligations are contractually due to the other party.

I’ve read arguments trying to justify the curriculum saying that credit loss appears when there are gains. This argument makes sense only if we talk about derivative instruments, e.g. swaps.

But if we just look at fixed income instruments, e.g. bonds and loans - which definitely bear credit risk, how do you explain a company defaulting? The company is making no gains ('cause it defaulted) and bondholders will definitely make a loss! Go tell a credit portfolio manager that the VaR on her loans portfolio should be calculated on the upper-tail of the distribution… the manager will laugh at you!

The fact that credit VaR should be calculated on the lower tail of the distribution is reinforced by the equivalence of debt with a risk-free bond + short put… value of debt decreases on the left