The Effects of a Shift in Monetary Policy Regime - Assignment Example

Modern Credit Risks are no longer defined by outright exposure and are currently calculated by a popular method of the Value at Risk (VaR)This method estimates the maximum amount of loss possible in a portfolio subject to certain periodic intervals and has its advantage of being comparative in nature, i.e it will allow the financial institutions in question to allocate capital more efficiently.(Chance 1979).These methods employ the risk level models of capital, which are used to estimate the profitability of capital, like the risk-adjusted capital (RORAC) or risk-adjusted return on capital (RAROC) and such models today, play a pivotal role in the management of risks inherent in the management of financial institutions.

In credit risk calculation VaR or Value at risk is a single numerical estimate which is an indicator of the possible maximum loss of a portfolio over a given time horizon at a certain confidence level. This methodology developed as a response to the financial disasters in the decade of the 1990s and has obtained an increasingly important role in risk management (market, credit and operational). The attraction of using VaR for credit risk assessment thus lies in the fact that it is able to provide a single quantity that states the overall market risks faced by an institution.

The criticisms have however stemmed from a recognized lack of coherence in the VaR methods and its failure to account for losses beyond a certain level and do not give due credit to the advantages of diversification by not taking into account sub-additivity.Various VaR models currently dominate the literature.These include the historical or (empirical) approach (see Van Der Vaart 1998), the Gaussian approach, the extreme value theory approach (which through the block maxima method (BMM) and the peak over the threshold (POT), focuses on variables above a given thresholdAlso relevant here are the interest rate risks which are related to the relative value of an interest-bearing asset diminishing due to a rise in the interest rate.

It can be calculated by a variety of ways to give an estimate as to how changing interest rates are impacting upon a bank's portfolio these include the "market value of portfolio equity" method which uses market value of the assets, analysis of the shifts within the Yield curve, the Value at Risk method, and measuring irregularities within the interest sensitivity gap of assets and liabilities. (Bower 1984).There are many main models for measuring credit risk and differ by the period at which they were used.

Value at Risk (VaR) is one of the most modern methods of measuring credit rate risk and is an integral part of the modern market risk measurement framework and it aims at expressing the total market risk as a single number, i.e. to summarize the expected maximum loss over a target horizon within a given confidence interval.