Value At Risk and Credit Risk

Abstract

In recent years increased volatility in interest rates, exchange rates,

and other macroeconomic variables has led us to put greater emphasis

on risk management. VAR (Value at Risk) has become a common tool to

measure an entity's exposure to market risk. But there are few studies

to link VAR with credit risk. This study examines the association

between the two with three financial statement-based estimates of

VARs. Moreover, we investigate whether the term spread and the default

spread affect the VAR metrics.

Results indicate that the VAR for speculative grade ratings is

significantly higher than that for investment grade ratings. After

controlling for the 2-score variables, which have been extensively used

amongst credit analysts, we provide strong evidence that the VAR

metrics are correlated with the credit ratings. Moreover, the findings

suggest that the magnitude of the cash statement VAR is positively

related to the term spread and the default spread. However, we could

not find evidence that the balance sheet VAR and income statement

VAR are affected by the term spread and the default spread.