12. Credit Risk Flashcards
Name 2 types of credit risk, an example for each of them and two ways to mitigate the risk.
- Lending (Zero coupon bond, line of credit, mortgage)
-> Mitigate risk with collateral and covenants - Counterparty credit risk (forward)
-> Mitigate risk with netting, collateral and central counterparties
What are credit derivatives? Name an example
A credit derivative is a derivative security with cash flows that depend on credit events. An example is a credit default swap (CDS)
What is the difference between credit risk that comes from a default and a market-to-market loss?
Default is when an entity does not pay its due (like in the case of a bankruptcy) while a market-to-market loss is when the creditworthiness of another entity changes and the worth of financial contracts with them is affected.
What are the 3 main basic credit model components?
- Probability of default
- Exposure at default (max value of loss)
- Loss given default (proportion of exposure lost)
Describe a Markov Chain Model used for credit risk
A Markov Chain Model used for credit risk uses transition matrices to determine if a certain firm will have a change in its credit worthiness through time.
What is the difference between a structural model and a reduced form model when we want to model credit risk?
A structural model will try to model the underlying process of the default while a reduced form model will simply propose a mathematical way to compute credit risk. In the first one, there is a “story” while there isn’t in the second.
Why is it important to modelize the credit risk of the entire portfolio?
Because the default of different firms is not always independant: there is some systematic risk. It is important to understand that in times of crisis (like in 2008), defaults will happen a lot more and are not independant (tail dependency).
