As the ability to model and monitor risk has become more sophisticated, this static and rather simplistic approach has given way to more complex measures of risk. As discussed in Chapter 2, this measure indicates how potential market movements can impact the value of a portfolio of transactions with a given probability over a period of time. Measuring credit risk with VaR requires an adjustment to the methodology because the time horizon being evaluated is essentially the life of the transaction. This is because, unlike market risk which can be readily hedged, credit risk is more difficult to manage. When analyzing credit risk, an important issue to consider is the potential for netting.
Many companies have numerous open transactions with a given counterparty at any point in time.
While there may be significant credit risk on a gross basis, the net exposure may be considerably less. The benefits of these products are clear. Essentially, firms can increase flexibility and reduce costs by transferring credit risk without having to liquidate instruments or portfolios. This could reduce the risk time-horizon issue discussed earlier. However, while interesting in concept, it is important to note that the credit derivative market is still fairly illiquid and, to date, usage has been limited and valuations are difficult.