The CDS markets portfolios (sensitive to credit events) construction is important especially for banks and investment management. Can we use VAR measure to assess the risk of such portfolio? if yes, what could be the possible practical implications of VAR for CDS portfolio?
Yes you can. The VaR measure gives the maximum potential loss the CDS portfolio could incur.
It is counter intuitive, AS the product is intended it is priced as an insurance and insurance premiums are not in the nature of a credit and do not follow valuation logic amenable to VAR
Sir mittal thanks for the answer. Can you please elaborate why a product whose price is determined by the credit quality of underlying cant to be subject to risk. If lets suppose the rating degrads would it not impact the price. And if it would, then isn't there any risk?
VaR are inherently for products with risk of credit or price loss, but as Sergei mentions we are intuitively pricing the insurance premium on the improbability of default and adding back costs to get premium.
Premium = EL + Costs of contracting + costs of funding loss capital provisions (if any)
This 99% improbability of loss would indeed have been VAR but we are already using it to price the insurance, thence you would not be able to provide VaR based capital for it but provide the entire pool premium to the loss event per se and realise profits when the event does not happen. You could indeed use a quasi VaR EL methodology to price the insurance.
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