Credit Value at Risk (cVAR) is a measure of the potential economic loss on credit exposures due to credit events. Credit Value at Risk may be calculated for individual assets, portfolios, or even institutions.
It can be expressed in absolute terms, such as Euros or Dollars, or as a percentage of total exposure. The calculation requires three inputs: the current market price, the planned sales price, and their respective default probabilities.
It becomes important to calculate credit value at risk when there is a need to determine the level of an institution's capital adequacy requirement.
In this article, we will be talking about credit value at risk, what causes it, and how to calculate it.
What is Credit Value at Risk
Credit Value at Risk is a number that tells you how risky your credit portfolio is. It will tell you the unexpected losses of the credit portfolio over one year at some confidence level. The losses are expressed in terms of currency units or credit exposure.
It helps banks and financial institutions to determine the level of their capital adequacy requirement. In other words, it is a measure of how much money you stand to lose from exposure to credit risk over one year under normal market conditions.
What causes Credit Value at Risk
Credit Value at Risk is influenced by three factors
- The probability of default for each obligor in the portfolio
- The exposure to the obligor at default, or collateralization level which is defined as the percentage of the exposure that would be lost if the counterparty defaults
- The exposure at default is modified by a credit conversion factor which reflects the expected loss that would be incurred in a worst-case scenario, such as a downturn of the economy or a systemic crisis
Importance of Credit Value at Risk
This is a measure of the amount that you could lose from a credit portfolio over one year under normal market conditions. It is important to determine levels of capital adequacy requirement in order to show prudence in making business decisions and effective management of risk.
How to calculate Credit Value at Risk
In general, there are three steps in calculating Credit Value at Risk
Step 1 - Define the inputs needed. First, list your portfolio of assets or credits. Next, you need to obtain the current market value of each asset or credit. And thirdly, obtain the expected probability that is being assigned for each borrower breaching their loan agreement/contract terms during the year.
Step 2 - Calculate the expected loss for each instrument in your portfolio
Expected Loss = Probability of Default X Exposure at Default X Loss Given Default
Loss Given Default = 1 – Recovery Rate
Step 3 - Calculate Credit Value at Risk
The loss distribution of the credit portfolio is determined by simulation, and the Credit Value at Risk is calculated as follows,
Credit Value at Risk=Worst Credit Loss-Expected Credit Loss
Conclusion
Credit Value at Risk is a number that tells you how risky your credit portfolio is. This number tells you the unexpected losses over one year at a confidence interval. The losses are expressed in terms of currency units or credit exposure. The capital adequacy ratio helps banks and financial institutions to figure out how much money they need.
Originally Published Here: Credit Value at Risk (cVAR): Definition, Formula, Calculation, Interpretation
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