In January 1999, QT highlighted some of the commonalties and differences between market risk and credit risk. That article focused primarily on the management of credit exposure as distinct from credit risk. As pointed out, they are two faces of a single phenomenon - uncertainty - affecting financial markets, but require in general fairly different approaches. A new trend in the industry to unify market risk and credit risk management adds some confusion to the picture. It might then be helpful to revisit the analysis from a different perspective: this is where event risk comes to play.
Market risk is related to changing conditions that affect the total value of the trading book. It can be neutralized by hedging, so measurement and control focus on the short-term horizon required for doing so. In contrast, credit risk is related to the creditworthiness of each counterparty, taken individually over the full life of the transactions in each customer's portfolio (although the credit exposure during that period is only influenced by market factors). Until recently, such risk could only be diversified. Today, in some cases, it can be transferred, hedged or insured thanks to the development of credit derivatives.
Despite the objectivity of some of these distinguishing characteristics, the boundaries between market and credit risk are sometimes tenuous. The bridge between the two may be the perspective of event risk. Event risk is not a new risk category distinct from the conventional ones. Rather, it is a dimension that is common to all of them.
Regularity of Randomness
An important aspect in risk management is the degree of regularity of random events. At first, "regular random events" sounds like a meaningless oxymoron. In …