3.2 Credit Risk

Question 1

Five credit events:
1. B
2. CD
3. F
4. CE
5. GA

Answer 1

1. bankruptcy (dissolution or insolvency of an entity when it is unable to meet its obligations)
2. credit downgrade (rating is downgraded by a credit rating agency)
3. failure to pay (borrower fails to make scheduled principal or interest payments, even if it is not in bankruptcy or in distress)
4. corporate event (mergers or spinoffs, which could weaken an entity’s financial condition and capacity to service its obligations)
5. government actions (such as capital controls or restrictions by governments)

Question 2

Several measures are critical in measuring credit risk. Exposure at default (EAD) measures (1). Loss given default (LGD) measures the (2). LGD is typically (??) than EAD.

Answer 2

Several measures are critical in measuring credit risk. Exposure at default (EAD) measures a creditor’s potential loss if a credit event occurs.

Loss given default (LGD) measures the loss (and therefore recovery) in a default scenario. LGD is typically less than EAD

Question 3

Borrowers often have more information than lenders, which is referred to as AS. AS raises a lender’s risk. In turn, the lender may choose to offset this risk through ______. This results in an increase to ________, therefore increasing CR. To offset this risk, lenders, such as large institutions, require additional credit protection, including C, limits on LA, and verification of a borrower’s credit profile and history.

Answer 3

Borrowers often have more information than lenders, which is referred to as adverse selection. Adverse selection raises a lender’s risk. In turn, the lender may choose to offset this risk through higher interest rates. However, as lenders raise interest rates, the borrower’s cost of financing increases, therefore increasing credit risk. To offset this risk, lenders, such as large institutions, require additional credit protection, including collateral, limits on loan amounts, and verification of a borrower’s credit profile and history.

Question 4

Adverse selection arises before completion of a financial transaction. In contrast, MH arises after completion of a financial transaction

Answer 4

Adverse selection arises before completion of a financial transaction. In contrast, moral hazard arises after completion of a financial transaction.

Question 5

Moral hazard vs adverse selection - timing of arising?

Answer 5

Adverse selection arises before completion of a financial transaction. In contrast, moral hazard arises after completion of a financial transaction.

Question 6

Moral hazard:
- when arising
- what
- how to protect against?

Answer 6

Moral hazard arises after completion of a financial transaction - arises when the borrower takes on more risk knowing that the counterparty (lender) bears the risk of the transaction.
Lenders can protect against these risks through monitoring, various restrictions, and limiting loan sizes.

Question 7

As the recovery process on a defaulted loan can be long, it is better to use the present value of the recovered amount. Formula is

Answer 7

Amount to be recovered discounted at RF rate. i.e. For example, the RR is 35% on a loan of $175 million, to be recovered over four years using a discount rate of 6.5%. The implied RR is found to be 27.21%, as shown here:

amount to be recovered = 0.35 × $175 million = $61.25 million

present value of planned recovery = $61.25 / (1 + 0.065)^4 = $47.611 million

recovery rate = $47.611 / $175 = 27.21%

Question 8

How to calculate expected credit loss using PD, LGD, RR, EAD.

Answer 8

Calculate the LGD:

LGD = EAD * (1 - RR)

E[loss] = LGD * PD = EAD * (1 - RR) * PD

Question 9

For example, the EAD is $175 million, the RR is estimated to be 27.21%, and the estimated probability of loss is 0.75%. What is the expected credit loss?

Answer 9

LGD = $175 × (1 – 0.2721) = $127.38

E[Loss] = $127.38 × 0.0075 = $0.955

Question 10

What are the 3 types of credit risk modelling?
1. SCRM
2. RFM
3. EM

Answer 10

1. structural credit risk model (calls/puts)
2. reduced form model (random)
3. empirical model (creditworthiness)