Estimating Credit Spread Risk Using Extreme Value Theory

Wesley Phoa, Ph.D.

In 1998, many fixed income investors grossly underestimated the extent of credit spread risk. The main reasons were a failure to take heavy tails into account when estimating risk, and a failure to incorporate a sufficiently long history of credit spreads into the statistical estimation process. This brief, non-technical article shows how longer term daily data, combined with extreme value analysis, can be used to generate more accurate and robust quantile estimates for credit spread shifts.