Sunday, October 17, 2010

credit risk in trading vs commercial banking

Hi Rob,

I feel there are 2 major users of credit risk data.

* traders use it as part of market risk data
* lenders use it to decide on interest rate and perhaps collateral

Everyday thousands of individuals and organizations borrow money from banks, from corporate/muni bond markets, from repo market, from swap market ... The interest rate they pay is calculated based on their credit score or credit rating. Essentially it boils down to default risk. For example, Treasuries have the lowest interest because these issuers have the maximum credit rating, even though the Greece government can default just as any issuer.

It's impossible to "guess" how much interest to charge a borrower. It has to be calculated. Therefore, Credit risk is an indispensable system for lending institutions. Not for traders. I feel traders generally look at market risk numbers after executing a trade. That's the all-important concept of VaR.

Credit risk (and market risk) data help traders get a better idea of their risk exposure, and may prompt them to set up hedges or trade less/more aggressively going forward. However, a trader could choose to trust her intuition more than the risk numbers.

Please correct my understanding. You can simply put "no" after any incorrect observation. If you can explain it's even better. Thanks.

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