Risk management distinguishes between market risk and credit risk. Market risk is
the risk of price movement due either directly or indirectly to changes in the prices
of equity, foreign currency, and US Treasury bonds. Credit risk is the risk of price
movement due to credit events. A credit event is a change in credit rating or perceived
credit rating, which includes default. Corporate, municipal, and certain sovereign
bond contain credit risk.
In fact, it is sometimes difficult to distinguish between market risk and credit risk.
This has led to debate over whether the two risks should be managed together, but
this question will not be debated here. Most people are in agreement that the risks
are different, and risk managers and their models must account for the differences.
As will be seen below, our framework for a credit risk management model contains a
market risk component.
There are several reasons why Markowitz’s portfolio selection model is most easily
applied to equity assets. First, the model is what is called a single-period portfolio
model that tells one how to optimize a portfolio over a single period, say, a single day.
This means the model tells one how to select the portfolio at the beginning of the
period and then one holds the portfolio without changes until the end of the period.
This is not a disadvantage when the underlying market is liquid. In this case, one
just reapplies the model over successive periods to determine how to manage the
portfolio over time. Since transaction costs are relatively small in the equity markets,
it is possible to frequently rebalance an equity portfolio.
A second reason the model works well in the equity markets is that their returns
seem to be nearly normal distributions. While much research on equity assets shows
that their returns are not perfectly normal, many people still successfully apply
Markowitz’s model to equity assets.
Finally, the equity markets are very liquid and deep. As such there is a lot of data
from which to deduce expected returns and covariances of returns.
These three conditions of the equity markets do not apply to the credit markets.
Credit events tend to be sudden and result in large price movements. In addition,
the credit markets are sometimes illiquid and have large transaction costs. As a
result many of the beautiful theories of market risk models do not apply to the credit
markets. Since credit markets are illiquid and transactions costs are high, an
appropriate single period can be much longer that a single day. It can be as long as
a year. In fact, a reasonable holding period for various instruments will differ from a
day to many years.
The assumption of normality in Markowitz portfolio model helps in another way. It
is obvious how to compare two normal distributions, namely, less risk is better than
more risk. In the case of, say, credit risk, when distributions are not normal, it is not
obvious how to compare two distributions. For example, suppose two assets have
probability distribution of losses with the same mean but standard deviations of $8
and $10, respectively. In addition, suppose they have maximum potential losses of
$50 and $20, respectively. Which is less risky? It is difficult to answer and depends
on an economic utility function for measuring. The theory of utility functions is
another field of study and we will not discuss it further. Any good portfolio theory for
credit risk must allow for the differences between market and credit risk.
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