Assess the use of JP Morgan Company’s Solution Credit Metrics as a tool for assessing credit risks.

Assess the use of JP Morgan Company’s Solution Credit Metrics as a tool for assessing credit risks. 

Ans. The left hand graphic reflects how marginal contribution to portfolio risk increases geometrically with exposure size of an individual obligor, more noticeably so for weaker credits. Consequently, as illustreated in the right hand graphic, to maintain a constant balance between risk and return, proportionately more return is required with each increment of exposure to an individual obligor. Risk is measured in terms of its threat to shareholder capital. The idea is that if a firm’s liabilities are constant, then it is taking risk by holding assets that are volatile. Such risk- taking capacity is not unlimited and must be allocated as a scarce resource. For example, if a manager found that there was a ten per cent chance of a decline in portfolio value occurring in the next year severe enough to cause organization-wide insolvency, then he would likely seek to decrease the risk of the asset portfolio. For a portfolio with a more reasonable level of risk, the manager cannot add new expo-surest indiscriminately, since eventually the portfolio risk will surpass the “comfort level.” Thus, each additional exposure utilizes a scarce resource, which is commonly thought of as risk-taking capacity, or alternatively, as economic capital. Consequently, as an indicator of economic capital, a percentile level seems quite appropriate. Using, for example, the first percentile level, economic capital could be defined as the level of losses on the portfolio that, with 99 per cent certainty, will not be exceeded in the next year. The approach described here benefits from the comparison in at least three respects: 

Sensitivity to obligor credit quality 

Sensitivity to portfolio concentrations 

Uniform treatment of value-at-risk due to credit, irrespective of the underlying instrument