The Global Financial Crisis (GFC) highlighted the importance of measuring and understanding extreme credit risk. This paper applies Conditional Value at Risk (CVaR) techniques, traditionally used in the insurance industry to measure risk beyond a predetermined threshold, to four credit models. For each of the models we use both Historical and Monte Carlo Simulation methodology to create CVaR measurements. The four extreme models are derived from modifications to the Merton structural model (which we term Xtreme-S), the CreditMetrics Transition model (Xtreme-T), Quantile regression (Xtreme-Q), and the author's own unique iTransition model (Xtreme-i) which incorporates industry factors into transition matrices. For all models, CVaR is found to be significantly higher than VaR, and there are also found to be significant differences between the models in terms of correlation with actual bank losses and CDS spreads. The paper also shows how extreme measures can be used by banks to determine capital buffer requirements.
The severe bank stresses of the Global Financial Crisis (GFC) have underlined the importance of understanding and measuring extreme credit risk. The Australian economy is widely considered to have fared much better than the US and most other major world economies. This paper applies quantile regression and Monte Carlo simulation to the Merton structural credit model to investigate the impact of extreme asset value fluctuations on default probabilities of Australian companies in comparison to the USA. Quantile regression allows modelling of the extreme quantiles of a distribution which allows measurement of capital and PDs at the most extreme points of an economic downturn, when companies are most likely to fail. Daily asset value fluctuations of over 600 Australian and US investment and speculative entities are examined over a ten year period spanning pre-GFC and GFC. The events of the GFC also showed how the capital of global banks was eroded as defaults increased. This paper therefore also examines the impact of these fluctuating default probabilities on the capital adequacy of Australian and US banks. The paper finds highly significant variances in default probabilities and capital between quantiles in both Australia and the US, and shows how these variances can assist banks and regulators in calculating capital buffers to sustain banks through volatile times.
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