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In order to manage any type of risk, it becomes important to measure it. Now, credit risks manifest in different forms within an organization and within its environment. It is for this reason, it is important to know that there is no direct way to measure credit risk. Instead, any organization has to look at a series of metrics in order to evaluate the quality of credit of their portfolio. In this article, we will have a look at some of the measures which are commonly used to measure credit risk.
There are certain features of credit risk that make it more complicated as compared to other risks:
Firstly, credit risks tend to be extremely long-term in nature. Since it is difficult to predict the long term with any accuracy, credit risk management is considered to be a difficult proposition
In order to manage credit risk, the company has to manage both the pricing risk which would change the mark to market valuations in the short run as well as default risks in the long term.
There are various types of exposures that companies may have with different counterparties. In order to formulate a correct strategy, they all have to be brought on the same page. This can be quite challenging for any organization.
In order to manage any risk, it is important to understand the spectrum of values that the investment can possibly have in the future. In the case of market risk, Value at Risk (VaR) is used to understand the risk. However, VaR is extremely short-term in nature. Credit risks, on the other hand, tend to be quite long-term and may continue for years. It is for this reason, that organizations have come up with a metric called as expected mark to market value.
The expected mark to market value is different as compared to the mark to market value. This is because the expected mark to market value is a future hypothetical number whereas the mark to market value is a fact. Credit analysts have to take into account the future cash flows, stability of these future cash flows as well as the possible interest rates in the future in order to determine what the expected mark to market value will be in the future.
Expected exposure is the value that is actually owed back to the lender. The mark to market value of the debt may change based on external factors. However, the expected exposure only changes as per the repayment schedule. The expected exposure is maximum during the early part of the tenure of any loan and is subsequently reduced towards the end. However, since most bonds pay principal at the end, the expected exposure value can be thought of as being significant towards the end.
The expected positive exposure is another variant of the expected exposure value. In simple words, it is an average of the various exposures over a period of time. Since the exposure keeps on changing over time, there is a need for a single number that can quantify the exposure. Expected positive exposure is that number. This number is used in a lot of formulas related to credit risk management. It is widely used to assess counterparty risks as well as to price instruments that protect organizations from such risks.
However, the expected positive exposure metric has a shortcoming. It is biased towards long-term investments. It is for this reason that this metric has to be modified to a certain extent if it has to be used to measure short-term credit exposures.
Potential future exposure refers to the maximum exposure which a firm can have towards a loan. The PFE metric is very similar to the VaR metric. This is because it also provides a confidence range about what the value is expected to be in the future. For instance, it can provide a value with 90% confidence. This means that the probability of loss is less than 10% (100% - 90% confidence).
The important difference between VaR and PFE is that PFE does not measure loss. Instead, it measures exposure. Hence, if a loss does not occur, the exposure actually becomes again. Hence, it is often said that VaR is used to predict the worse case loss whereas potential future exposure is a metric to measure the worst-case gain.
In risk management, it is important to calculate the maximum loss that a company could face at a given point in time. This is why maximum potential future exposure is an important metric. It allows the company to keep an eye on exposure and bring it under control if they suspect that a negative credit event is about to happen in the near term.
Ideally, every organization should have a dashboard where they continually track these metrics. Healthy ranges for these metrics are defined in the risk policy of the company. If the actual values start breaching the ranges, then corrective action needs to be taken by the credit risk management team.
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