Colonial First State Global Asset Management
Measuring credit portfolio risk
Tony Adams, Senior Portfolio Manager
Leah Kelly PhD, Assistant Portfolio Manager
October 2006
Credit investing is a strange beast. The question “How
much risk am I taking?” is not easily answered.
Traditionally with an equity portfolio the answer is usually
expressed as a volatility or tracking error number. For fixed
interest and credit portfolios the answer might be a
duration number, an average credit rating or even a
tracking error number or Value at Risk (VaR). Unfortunately,
all these measures for credit portfolios can be significantly
deficient by failing to capture the true risk profile of credit
investments. This paper explores the issue of the
inadequate reporting of portfolio credit risk in the hope
that it ignites industry discussion and promotes a push for a
more standardised reporting model.
There is one simple but significant difference between bonds
and equities: the distribution of the returns of a bond can not
be estimated by use of a normal distribution. The diagram
below highlights the difference between the normal
distribution that is usually used for equity risk management
and an asymmetric fat tailed distribution as faced by fixed
interest portfolio managers.
Bonds have limited upside (all that can be earned is the
promised coupon plus a return of principal) while the
downside is potentially 100%. A defaulting bond will return
less than full principal and may return nothing. Equities,
however, while having the same 100% downside also have the
potential for significant upside. In this case, the normal
distribution is often used as a reasonable proxy for an equity
return distribution. All that is required to describe the return
distribution is a mean and a variance, or an expected return
and a tracking error.
Bonds do not perform this way and therefore additional
parameters are essential in adequately describing their return
distribution.
Put simply, bonds have interest rate risk (which all bonds have
to differing degrees) and credit risk. It is commonly
understood that government bonds are ‘credit risk free’ and
this is the premise we use. For this paper the term bonds will
refer to bonds incorporating credit risk.
This paper discusses the common metrics used in the industry
to measure the credit risk of a portfolio. It seeks to highlight
the benefits, flaws and assumptions of each of these
approaches. A standard approach is proposed to enable a
true relative comparison of credit portfolio risk. The theory
and approach discussed in this paper is well documented and
firmly established.1 Leading global credit portfolio managers
are implementing risk measurement and management
approaches using these techniques.
The diagram below summarises the findings of this paper by
ranking the effectiveness of the various commonly used
measures of credit risk by their overall effectiveness.
• Tail Risk
Effectiveness of Credit
• Value at Risk
(VAR)
Risk Measure
• Tracking error
• Credit Duration
• Average Credit
Rating
As will be discussed in this paper the key risk in credit
portfolio management is the risk of extreme losses (known as
tail risk) and the other measures above are ineffective at
adequately capturing this risk.
1
Many examples exist, see:
Artzner, P., Delbaen, F., Eber, J. & Heath, D. (1997), “Thinking coherently”,
RISK, 10 (11), 68-71
John B. Caouette, Edward I. Altman, and Paul Narayanan, “Managing Credit
Risk”, New York, 1998, John Wiley & Sons, Inc
Dimitris Chorafas, “Credit Derivatives & The Management of Risk”, New York,
2000, Prentice Hall
Credit Derivatives Insights, Single Name Instruments & Strategies, Morgan
Stanley 2006, various authors
 Colonial First State Global Asset Management 2

This paper does not imply that the value of high quality credit
analysis and stock selection in the management of portfolios
to reduce credit losses is in any way diminished. It addresses
the portfolio construction elements of credit portfolio
management.
It must always be remembered that any risk measure is only
as good as the assumptions underlying the modelling. This is
as true for the approaches suggested in this paper as it is for
the simpler ones discussed. A thorough knowledge and
understanding of the nature and implications of any
modelling assumptions is a necessary prerequisite for
effective use of that model in real world applications.
Credit risk
What is credit risk?
what is the likelihood that another borrower will default.
Often, due to industry factors, defaults occur in groups, such
as the telecom equipment sector in Europe or the airline
industry in the US. Portfolios where the assets have high
default correlation are more likely to experience default
clustering than those with low default correlations.
Concentration refers to holding large positions in specific
names. As defaults can occur randomly, the size of an
investors holding when an asset defaults will directly impact
the loss effect on the portfolio. A large holding will cause a
large loss and a small holding a small loss.
The key parameters that impact the credit risk of a portfolio
are:
• Underlying credit risks,
• Default correlations and
• Exposure positions (concentrations).

Risk is the chance that an investment will not generate its The following chart shows the actual historical default rates
expected return. In the case of bonds this may incorporate for triple-B rated credits since 1970.
interest rate risk and credit risk. Credit (or default) risk is the
risk that the specific investment or portfolio will not generate
the returns as expected, due to the failure of the borrower to
Default frequency for Baa-rated credits
repay the principal and interest when due. 1.4%

1.2%
Market risk versus credit risk
1.0%
It is important, when looking at credit risk, to distinguish Average default rate
0.8%
between credit risk and ‘market risk’. Market risk arises when 0.17% per annum
the market price of assets changes due to changing market 0.6%
factors. These may be interest rates or credit spreads. This 0.4%
paper does not focus on the market risk (interest rates or
0.2%
spreads) of bonds.
0.0%
Due to the fact that, unlike equities, bonds mature, market
70
72
74
76
78
80
82
84
86
88
90
92
94
96
98
00
02
04
risk only exists to the extent that an investor’s investment or
19
19
19
19
19
19
19
19
19
19
19
19
19
19
19
20
20
20
return horizon differs from the maturity profile of the
underlying investments. Thus an investor with a one year
horizon who buys a 10 year bond will face market risk when
Source: Moody’s Investor Services
they go to sell that bond (with nine years remaining to
maturity) in the market one year later. If the investment
horizon and the investment are the same then the investor The chart shows that triple-B rated credits default ‘on
will earn exactly what they expected to, as long as the bond average’ at a rate of 17 basis points per year (0.17% p.a.). But
does not default. they never default at exactly 17 basis points per year (0.17%
p.a.). Sometimes no triple-B’s default and in some years quite
When an investor’s actual return and expected return are the a few do. It is also important to note that these are
same, there is no risk. Thus, in this case the only risk faced by ‘averages’ across the entire rated universe of bonds, whereas
the investor is the risk of the borrower defaulting. portfolios will always own a much smaller number of bonds.
The impact of this concentration can be significant. While the
‘average’ triple-B default rate in 2002 was 1.21% a portfolio of
What is portfolio credit risk? 10 triple-B’s that owned WorldCom and Enron (defaulted Dec
When making a credit investment there is always the risk that 2001) would have had a triple-B default rate of 20%!
the borrower might default on its debt. For strong
investment grade borrowers this risk is very low but still Credit migration is a term often used when describing credit
exists. Therefore, anyone investing in credit must expect a portfolios. Migration refers to the changing of a credits
certain rate of default. Defaults are expected and the rating through time. A bond issued by a company rated
occurrence of a default does not directly constitute risk per single-A might experience some difficulty or additional
se. Portfolio credit risk is the risk that defaults, or losses due leverage and be downgraded to a triple-B or double-B rating.
to defaults, run at a different (especially higher) level than is Migration might also be an improvement in rating. Migration
expected. Best practice credit portfolio management is does impact the market value of assets and a less
primarily about ensuring that losses due to defaults do not concentrated portfolio (smaller positions) will be less
run at a higher rate than expected. susceptible to the impact of price changes due to specific
names migrating. However it must be remembered that
Portfolio credit risk is derived from the credit risk of the migration is a measure of market risk and not, except in the
underlying bonds, but two other factors are equally extreme of migrating to a defaulted state, credit risk. If an
important; correlation and concentration. Correlation is a investor’s investment maturity matches their investment
term used to identify things that move together, that is the horizon the only risk they face is credit or default risk. As
strength of the relationship between variables. Default migration is a market risk and not a credit risk it will not be
correlation tells us, given a certain borrower has defaulted, explicitly covered in this paper.
 Colonial First State Global Asset Management 3

Traditional measures of credit risk

Average credit rating
The average credit rating is the simplest and a very common
tool used to ‘measure’ the credit risk within a portfolio. It is
also arguably the most misleading.

The average credit rating is simply a measure of the ‘average’

credit rating of all the individual assets in the portfolio. The
first problem with this approach is that many participants use
a scale that is too simplistic when calculating the average and
the second is that it ignores the universally accepted benefit
of portfolio diversification. The third is that average credit
rating is not a measure of risk. As mentioned risk is a
measure of uncertainty (like standard deviation), the
‘average’ of anything is a measure of central tendency, a
measure of what you do expect, and not a measure of how
wrong you might be.

Many participants use a linear scale when calculating

‘average portfolio credit ratings’ thus a AAA is given a score of
1, AA+ of 2, AA of 3, AA- of 4, A+ of 5 and so on. The portfolio
credit rating is then determined by weighting the scores by Source: Moody’s Investor Services3
the weights for each bucket.
Linear versus non linear calculations
Credit ratings indicate a certain probability of default. The
For example a portfolio might look like the following:
following table shows the cumulative probability of default
for various rating bands based on Moody’s historical data2.
Rating Weight
AAA 30%
AA 10%
Moody's 10 year cumulative
Rating historical default A 20%
probability BBB 30%
Aaa 0.60% BB 10%
Aa 0.78%
A 1.24% Using a linear scale this portfolio would have a ‘weighted
average’ rating of ‘A’ but using a more realistic default scale
Baa 3.63%
the ‘average rating’ would be more like BBB-. A linear scale
Ba 27.39%
significantly understates the ‘average’ default probability of a
B 50.42%
portfolio and needs to be used with extreme caution, or more
appropriately not used.

Thus 3.63% of issues rated BBB have defaulted within 10 years
of them being rated BBB. It can easily be seen that stepping
down in credit quality does NOT result in a linear increase in
default probability. The default risk increase is significant and
non-linear as the rating falls. The following chart of one, five
and ten year default rates by Rating Category clearly displays
this.
However, even if a more realistic scale is used, the ‘average’
does not consider the degree of portfolio diversification or
concentration which reduces the effectiveness of this
measure. While BBB securities are expected to default with
an annual probability of 0.17% this does not mean that
exactly 0.17% of BBB’s will default each year. Some years
none will default and in other years the default rate might be
above 1%. This is the nature of risk and it is exactly this
volatility of actual default outcomes, around the long run
expected default rates, that generate portfolio risk.

A portfolio of 10 BBB Australian utility securities will have an

average rating of BBB. A portfolio of 1,000 BBB globally
diversified securities will also have an average rating of BBB.
However, the portfolio risk of each is significantly different.
It will only take 1 default to generate a significant loss in the
first portfolio (and indeed if the default is due to industry or
regional factors and correlation is high more than one default
is possible) where as it would take 100 defaults in the second
portfolio to generate the equivalent negative impact. This
shows that while the ‘expected’ outcome of both is the same
2
Moody’s Investor Services “Default and Recovery Rates of Corporate
3
Bond Issuers, 1920-2004” January 2005 ibid
 Colonial First State Global Asset Management
the potential to deliver a significantly different ‘actual
outcome’ between the portfolios is high.
Clearly, knowing that a portfolio has an average rating of x
provides no meaningful information about its risk – it may
however give you an indication of the returns you should
expect to receive.
Credit duration
Another component of ‘credit risk’ is credit duration. As with
interest rate duration, this gives a measure of how much a
portfolio might lose if credit spreads were to widen by a basis
point. It is mathematically related, among other things, to
the length of the exposure. Thus a portfolio with credit
duration of 4 would expect to lose 4% if credit spreads were
to widen by 1% and a duration of 2 would indicate that a
portfolio would expect to lose 2% if credit spreads were to
widen by 1%. It is a measure of market risk and not credit
default or migration risk.
Credit duration, as it is typically applied, assumes that all
securities irrespective of their
• rating
• term to maturity
• currency
• country
• industry
• level of subordination and
• security type
have credit spreads that widen by the same amount.
To further illustrate these assumptions, the use of credit
duration to ‘measure’ credit risk assumes that if the spread on
a 10 year US single B rated subordinated airline bond
widened by 10 basis points then the spread on an AUD AAA
rated, 1 year Super Senior Mortgage Backed Security would
also widen by exactly 10 basis points.
While credit duration gives a good ‘back of the envelope’
measure of what might happen to a portfolio if credit spreads
were to uniformly change, it makes no assessment on the
likelihood of that happening and does not, in any way
measure credit migration or default risk.
Tracking error
Tracking error is the approach taken by many participants
when reviewing the performance of a portfolio against its
benchmark. Tracking error looks at excess return volatility as
a risk measure.
Tracking error may be measured ex-post (after the event) or
ex-ante (before the event). Ex-post tracking error uses the
actual volatility of the portfolios active returns (excess returns
above the benchmark). Therefore this measure calculates
what the excess return volatility was not what the current risk
is or will be. Ex-ante tracking error requires portfolio
modelling to estimate the future volatility of the portfolios
excess returns based on historical trends. It therefore
requires that history, to some extent, repeats itself.
The basic assumption here is that the ‘risk’ of a portfolio is
defined as the volatility of its excess returns to the
benchmark.
4
This approach has two major flaws
• The first is that it is indifferent between strategies
that lower total risk and those that increase total risk
of the managed portfolio if their variance (tracking
error) to benchmark is the same.
• The second is that it assumes that volatility is the
complete and appropriate measure of risk – thereby
assuming normally distributed portfolios. The fact
that returns from bonds are not normally distributed
means that we need to look deeper at the
distribution. The important part from a risk
management perspective is the downside or the tail
of the distribution. A portfolio could be built that
had small volatility but a large tail risk and this
tracking error would not capture this risk.
A further problem is that most tracking error risk analysis is
done on an ex-post basis so that a risk that does not
eventuate would not register as a risk. Indeed a low volatile
but catastrophic worst case outcome asset or portfolio could
present as an attractive investment alternative. For example
writing insurance contracts or selling an option raises
premium and looks like a good return profile until a claim is
made or option exercised.
Looking at the first flaw. The following table describes the
broad return expectations for two portfolios A & B
Portfolio A Portfolio B
Expected excess return 2% 2%
Expected tracking error 4% 2%
Expected information ratio 0.5 1.0
Using standard portfolio measures of tracking error and
information ratios portfolio B would be preferred to portfolio
A. The following chart demonstrates the two different
portfolio possibilities in a different way. In this chart it would
be natural to select portfolio A as a preferred portfolio
position. However, as soon as the benchmark portfolio is
introduced the picture becomes less clear. In the chart below
the blue star represents the benchmark portfolio. Which of
alternatives A or B is now preferred?
RETURN
A B
10
8
RISK
2 6 8
 Colonial First State Global Asset Management
Tracking error measures the relative volatility of the portfolio
against the benchmark (and not against zero). The
information ratio is the ratio of the excess return to this
tracking error. The idea is that a higher information ratio
demonstrates that higher returns are being earned for each
‘unit of risk’. Thus traditional analysis would select portfolio
B as the preferred portfolio even though it has higher
absolute volatility.
RETURN
A B
10
8 ‘Alpha’ = 2% ‘Alpha’ = 2%
Information
Information
Ratio =0.5 Ratio =1
2 6 8 RISK
The situation gets even more difficult when greater
differences like the following are presented where portfolio A
has a slightly lower return than portfolio B but much lower
risk.
RETURN
B
A not capture the migration and default risk of the portfolio
10
8 ‘Alpha’ = 2%
‘Alpha’ = 1%
Information
Information Ratio =1
Ratio =0.25
2 6 8 RISK
A simple measure such as ‘tracking error’ or volatility of
excess returns to a benchmark ascribes no benefit to absolute
volatility reduction and will therefore potentially reward
portfolios that increase risk (as measured by absolute
volatility) over those that reduce it.
The second flaw with tracking error as a measure of risk in
bond funds is that it is inadequate in describing the
distribution of portfolio outcomes. The useful characteristic
of a normal distribution is that it can be completely
characterised by two parameters – the mean and standard
deviation, or in portfolio speak the expected return and the
tracking error. This distribution describes expected portfolio
returns from equities and equity portfolios reasonably well,
although the student-t distribution may provide a better
estimate. However, as discussed, in fixed interest there is no
significant upside (all you will get back is your principal and
promised coupon) yet still the possibility of significant
downside. The distribution of returns of fixed interest (credit)
5
portfolios cannot be modelled with a normal distribution and
cannot be adequately described with a single measure
(tracking error or otherwise).
The diagram below plots the theoretical future value
distribution of a credit portfolio. As can be seen a portfolio
worth $100 today is never going to be worth $200 in a year
but may be worth zero. This gives the distribution the shape
we see below. Because of this typical portfolio distribution
for bonds, it is essential that, in addition to measuring the
volatility of returns (or unexpected loss (UL)), there is a
measure of the downside. We must be able to describe the
length and shape of the tail risk as shown in the diagram
below. This will give a measure of how much ‘extreme
downside’ risk is in a portfolio.
Mean / expected
Portfolio Value
Unexpected Loss (UL)
describes the width of
Probability
the modeled portfolio
value
UL
High correlations and
concentrations may
increase tail risk
Tail risk
$0 Portfolio value $100 $120
The major deficiency of tracking error is that it is a market
risk measure and not a credit risk measure. Even ex-ante or
forward looking tracking error models base their calculations
on historical volatilities and do not incorporate migration
tables or loss given default (lgd) estimates. As a result they do
they are modelling and are thus not measuring credit risk. To
measure the credit risk within portfolios more sophisticated
credit modelling tools are required.
Best practice measures of credit risk
Measuring tail risk
There are a number of techniques available for the estimation
of Credit tail risk (VAR) including Monte Carlo simulation and
extreme value theory. Further there are a number of
different tools available to model portfolio credit risk
including MKMV's Portfolio Manager, CreditMetrics, Credit
Suisse’s CreditRisk+ and Algorithmics Portfolio Credit Risk
Management tool. All these tools allow the construction of
portfolio loss distributions and thus the calculation of a
variety of tail risk measures. They do however build their
models on varying assumptions and a thorough
understanding of these assumptions and their implications
should be gained.
Many tail measures calculate a VaR (Value at Risk). This tells
us, with a given probability, over a given time frame, the most
we would expect to lose due to credit losses. Thus a 1 year,
99.5 (3 standard deviations) loss number of $x tells us that in
995 out of every 1,000 years we would expect to lose less
than $x. However it tells us nothing about the shape of the
distribution around this point. For example in those 5 years
where we might expect to lose more than $x, how much more
might we lose? And in how many of the 995 years would we
lose close to $x but less than it?
 Colonial First State Global Asset Management 6

A common criticism of VaR is that it does not, in all cases,

reduce in the case of diversification.4 Take the following
simple example of two bonds A and B, that default VaR: at a 10%
independently. Both bonds have two default states with confidence level VaR is
that single % amount on
probabilities 3% and 2%, recovering $70 and $90, respectively. the portfolio distribution
The bond redeems at 100 in all other scenarios. We assume

Probability
no market moves and the initial value of the bonds is
equivalent to the expected value. The table below illustrates
the scenarios; CVaR: is the
average of losses
given that the
Probability A B Portfolio losses exceed the
(A+B) VaR number
1 0.03 70 100 170 chosen
2 0.02 90 100 190
3 0.03 100 70 170
4 0.02 100 90 190
5 0.9 100 100 200
$x Portfolio value
The expected value of bond A and B is 98.9 and the expected
value of the portfolio is 197.8. A proposed consistent measure of tail risk (CVaR)
The table below shows the profit and loss under each Just as tracking error has come to be a well understood and
scenario; uniformly described statistic, it is necessary that a similar
uniform statistic be adopted within the industry for the
Probability A B Portfolio measurement of tail risk. Without an accepted standard
(A+B) measure comparison across portfolios would not be possible.
1 0.03 -28.9 1.1 -27.8 It is important to note that even with a standardised measure
2 0.02 -8.9 1.1 -7.8 that underlying assumptions need to be understood as
3 0.03 1.1 -28.9 -27.8 differences here can lead to different results.
4 0.02 1.1 -8.9 -7.8
5 0.9 1.1 1.1 2.2 It is suggested that a 1 year 20% tail is an appropriate market
standard for this measure for the following reasons:
The 95% VaR for bonds A and B is 8.9. The 95% VaR for the
portfolio is 27.8. That is, the VaR of the portfolio is greater • Given that most fixed interest / credit funds in the
than the sum of the individual VaRs for each bond. market are sold with a ‘suggested’ investment
Diversification within the portfolio is not recognised under timeframe of 3-5 years then a tail that measures
VaR. what might be expected to happen once every five
years is a more appropriate statistic.
Another criticism of the usual adopted VaR measures is that
the confidence intervals used are so far down into the tail as • A measure of 20% does more than just measure the
to be meaningless for analysis. It may well make sense for a extreme event and because it is measuring so much
bank to maintain enough capital to sustain a 1 year in 1,000 of the distribution it inherently picks up some of the
event but for a managed fund, which doesn’t maintain ‘unexpected loss’ characteristics of the distribution.
capital, their clients (and business) would have long
disappeared with losses even getting close to this number. Once we have agreed on the part of the distribution to
So what is a more appropriate measure of tail risk? measure it is essential that the industry is consistent in what
it is measuring. We would propose that a measure of the tail
A better measure of tail risk is the use of Conditional Value at that helps to describe the shape of the distribution rather
Risk (CVaR). CVaR is a measure of the tail that helps to than just putting a value on a single point. This is often
describe the shape of the distribution rather than just putting referred to as CVaR or Conditional Value at Risk and it
a value on a single point. It measures the expected loss given measure the expected loss given (conditional on) the loss
(conditional on) the loss being greater than the VaR. being greater than the VaR.
The diagram below shows a portfolio distribution and A unified measure of tail risk can thus be defined as:
highlights the difference between VaR & CVaR.
CVaRq = VaRq + E(X - VaRq|X > VaRq)

where VaR is Value at Risk at the q% probability level.

The tail would then be reported in basis points and would

allow calculation of risk adjusted expected returns.

4
Technically, this is violating the sub-additivity property. The sub-
additivity property is VaR(A)+VaR(B) ≥ VaR(A+B).
 Colonial First State Global Asset Management 7

A real example It can be seen that the tracking portfolio, despite its overall
characteristics being consistent with the benchmark, and
To demonstrate the usefulness of the tail measure against despite it running an ex-ante tracking error of only 32 basis
more traditional measures we have modelled a ‘low tracking points is much more risky than the benchmark.7
error’ portfolio against its benchmark portfolio.
It is not suggested that many managers might have such a
We have used an internationally recognised global broad concentrated portfolio only that a portfolio with a very low
index and a model low tracking error portfolio constructed to tracking error might be carrying a very large amount of risk
replicate the key parameters of that portfolio. The details of against the benchmark.
the tracking error, as reported by use of the BondEdge5 tool
are also detailed. We have modelled the parameters and tail While CFS GAM uses MKMV’s Portfolio Manager tool to
risk of each of the model and benchmark and present them calculate these tail measures, as was discussed previously, a
below. number of different tools are available in the market which
calculate tail risk estimates. While they use different
assumptions and techniques it is our belief that under
Tracking Benchmark consistent modelling assumptions all these models would
derive similar results.
Issuers 41 517
Exposures 53 1,812 It must be remembered that in looking at this portfolio going
forward (and tracking its performance) it may not experience
Duration 4.31 4.29 any defaults and it may well track the index portfolio very
Average Exposure well. However this does not mean that it didn’t take
189 6
(bps) significant credit risk in doing so.
Maximum
740 32
Exposure (bps) Summary of risk measures
Average Credit
BBB A/BBB The following table presents a brief summary of the risk
Rating
measures discussed in this paper and highlights their relative
advantages.
The one month annualised tracking error was calculated
using BondEdge to be 32bps. Measure Incorporates:
Default Concentration Term to Effect of Extreme
Probability effects Maturity Diversification Event Risk
Now consider the credit portfolio statistics calculated from Average
KMV Portfolio Manager6: Rating 9 8 8 8 8
Credit
Duration 8 8 9 8 8
Tracking
Error 9 8 9 8 8
Tracking Benchmark VAR
9 9 9 8 8
Tail Risk
Expected Loss (bpts) 14 9 (CVaR 9 9 9 9 9
Unexpected Loss (bpts) 175 112
80% VaR (bps) 92 63
80% CVaR (bpts) 1,010 378

The following diagram shows the tails of the two

distributions with the critical region highlighted.

7
To model the funds the following assumptions were made:

• The investment horizon is 1 year.

• The probability level of interest is 20%.
• Expected maturity dates are used allowing the
modelling of migration risk.
5
© CMS BondEdge • Default probabilities are derived from the issuer ratings.
A Moody’s preference and if unavailable, then S&P.
6
© Moody’s KMV
 Colonial First State Global Asset Management 8

Conclusion
There are many tools currently used to ‘measure’ credit risk.
Many of these, while benefiting from simplicity of calculation,
are significantly inadequate in answering the question “How
much credit risk am I taking”. Some such as average credit
ratings are not really risk measures at all. Credit duration and
tracking error are measures of market risk rather than credit
‘default’ risk. While Credit VaR is a major improvement it
suffers from telling nothing about the fatness or length of the
tail it is measuring.
This paper has proposed the use of CVaR as a market standard
for the measurement and, importantly, reporting of credit
risk. It proposes that CVaR be measured at the 1 year 20%
level as an appropriate level for the funds management
industry. Such a benchmark is necessary to enable
consistency across the industry and improve reporting
transparency and overall credit risk management practices.
Definitions
Correlation: a measure of how two factors move together. Thus default
correlation measures the impact of one borrower defaulting on another
borrower
CVaR: A unified measure of tail risk defined as:
CVaRq = VaRq + E(X - VaRq|X > VaRq)
where VaR is Value at Risk at the q% probability level.
Default probability: the likelihood of any borrower defaulting in a given period
(usually one year). Thus, based on historical observations, a triple-B security has
a 0.17% likelihood of defaulting in the next year
Diversification: the spreading of investments across a variety of different
securities or borrowers.
Duration: a measure of the average life of a fixed income investment
incorporating coupon and principal flows. The duration of a security provides a
good guide to its expected price change given a change in its yield.
Expected loss: the amount an investor would expect to lose, over the longer
term, by investing in credit. It is calculated as the probability of default
multiplied by the amount of loss in the event of a default. Thus if the expected
loss given a default of a Baa company was 50c in the $ the expected loss would
be 0.16% x 50% thus 0.08% or 8 basis points

Information Ratio: The ratio of excess returns (of a portfolio relative to its
benchmark) to tracking error. It is intended to show the return for risk of a
portfolio.

Rating: An alpha scale showing an assessment of the likelihood of default

usually published by an independent rating Agency such as Moody’s Investor
services, Standard & Poor’s (S&P) or Fitch. The following table outlines the
various scales and gives a brief description of each.

Assessment Moody’s Scale S&P and Fitch

Scale
Extremely Aaa AAA
Strong
Very Strong Aa1 AA+
Aa2 AA

Investment Grade
Aa3 AA-
Strong Aa1 A+
Aa2 A
Aa3 A-
Adequate Baa1 BBB+
Baa2 BBB
Baa3 BBB-
Ba1 BB+

or
Ba2 BB Speculative

High Yield
Ba3 BB- Grade
B1 B+
B2 B
B3 B-
currently highly Caa / D CCC / D
/

vulnerable/
defaulted
Distressed
Default

Disclaimer
The information provided in this document is given in good faith and is derived
from sources believed to be accurate. Neither Colonial First State Asset
Management (Australia) Limited, any associated companies, nor any of their
employees or directors give any warranty of reliability or accuracy nor accept
any responsibility arising in any other way including by reason of negligence
for errors or omissions herein. This disclaimer is subject to any contrary
provisions of the Trade Practices Act.
Tail Risk: The risk of an extreme negative event
Tracking error: A measure of how closely a portfolio is expected (or historically
has) tracked its benchmark. Mathematically it is the standard deviation of the
excess returns of the portfolio over the index.
Unexpected loss: The volatility of loss around the expected loss.

This document is not financial product advice and is intended to provide VaR: Value at Risk (VaR) measures the maximum potential loss on a group of
general information only. It is not a recommendation of any securities offered securities over some time period, given a specified probability. In other words,
by Colonial First State Asset Management (Australia) Limited or any other once a probability or degree of confidence has been set, VAR is the amount
company or person. It should not be considered as a comprehensive statement which represents the statistical maximum loss for a single security or group of
on any matter and should not be relied upon as such. It does not take into securities.
account any person’s individual objectives, financial situation or needs. Any
investor accepting this information should consider whether the information is
appropriate for them and consider talking to a financial adviser before making
an investment decision.

The Funds referred to in this document are issued by Colonial First State
Investments Limited ABN 98 002 348 352. Product Disclosure Statements (PDS)
for the Funds are available from Colonial First State. Investors should consider
the relevant PDS before making an investment decision. Past performance
should not be taken as an indication of future performance.