IRC as Credit Risk: How Rating Migrations Affect Market Value
Summary
The document asks whether the Incremental Risk Charge (IRC), especially its treatment of default and rating migration, should be considered market risk or credit risk. It compares IRC with Credit Valuation Adjustment (CVA) and questions whether IRC is better understood as a liquidity-adjusted credit value-at-risk measure. The discussion highlights the difficulty of drawing a clean boundary between market and credit risk in these models.
One answer points to an IRC methodology paper but does not explain its conclusions. Another cites the EBA’s 2011 draft guidelines: unchanged ratings imply no value change in the described approach, while migration effects may be mapped using observed or historical market spreads. That answer characterizes the draft’s framework as credit-focused, with market prices used to value rating changes. The evidence is limited to a draft guideline and an individual interpretation; the document does not establish that all IRC implementations work this way or resolve the comparison with CVA.
Key ideas
- The document frames IRC’s classification as a question about how default and rating migration enter the model.
- The cited EBA draft links value changes to credit rating changes in the described approach.
- Migration impacts may be estimated using current or historical spread data.
- The discussion presents one interpretation of a draft framework, not a universal definition of IRC.
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Full text
# What makes IRC a market risk? # What makes IRC a market risk? Since modeling leaves complete freedom we can assume both market and credit risks can enter the picture. However the minimum requirement is (migrations and) defaults simulation, how does this configure as "pure" market risk (especially in the latter IDRC case), as various people claim? Why would CVA be more credit-related than IRC? After all CVA is about prices and IRC about exposures and defaults (yeah, of course this is incorrect, but let's play the devil's advocate), even though they are both motivated by adverse market moves. (Atleast Brigo calls them both credit risks iirc.) Is it simply because of spreads simulation? Or because we're patching a market risk measure? Or is there a more sound reason? And why isnt IRC just a liquidity-enhanced credit VaR? I've been given very odd and contradictory answers, and wont state here my understanding of the issue to avoid introducing more confusion and hoping to hear a clear definition of the two risks. Which is not so easy given the blurring boundary. ## Answer by Dora (score 1) https://quant.stackexchange.com/a/20730 You find the IRC methodology paper written by Tim Xiao at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2426836 ## Answer by Mats Lind (score 0) https://quant.stackexchange.com/a/30063 Reading EBA:s draft guidelines on IRC from 2011, the following quote points at it beeing entirely in the credit risk domain: "20.3 If a simulation, e.g. the asset value process, has not resulted in a changed rating, no change in value shall be assumed..." No change in credit standing, no change in rating and no change in IRC, so IRC is fully credit related. Furthermore, in 20.4, regarding migration events, there is no word of incorporating changes in market prices of risk in the calculation, instead a preset rating-to-spread table should be used: "The impact of a rating migration on market prices may be estimated using either currently observed market data (e.g. spreads); or an average of historical market data observed...". So I would humbly say that in the EBA draft of 2011 we have a pure credit model, and market prices are only in it as a misleading name for how rating changes are mapped on economic impact in the model.
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