Measuring Credit Risk: The Credit Migration Approach Extended for Credit Derivatives

Abstract

Over the last few years, three approaches to measure credit risk in a portfolio context have emerged in the banking industry. The “credit migration approach”, as initially proposed by JP Morgan with CreditMetrics, is based on the analysis of credit migration, i.e., the probability of moving from one credit quality to another, including default, within a given time horizon (often arbitrarily taken to be one year). The first generation of credit migration models derive the forward distribution of the values of a credit portfolio, say one year forward, where the changes in value are related to credit migration only; interest rates are assumed to evolve in a deterministic fashion. The credit value-at-risk (CVaR) of a portfolio is then derived in a similar fashion as for market risk. It is the distance from the mean of the percentile of the forward distribution, at the desired confidence level. (This definition of CVaR applies to all credit models, and is independent of the underlying theoretical framework.)