6.2 - Credit Risk & Credit Derivatives

Question 1

Expected Credit Loss

Answer 1

Expected credit loss = PD * EAD * (1 - RR)

PD -> probability of default
EAD -> exposure at default -or- value of outstanding debt (remaining principal and promised interest)
1 - RR -> loss given default -or- 1 minus the Recovery Rate

Question 2

Risk Neutral probability of default - exact method

Answer 2

λ = (1 / 1 - RR)(s / 1 + r + s)

Question 3

Risk Neutral probability of default - approximate method

Answer 3

λ ~ (s / 1 - RR)

-> equation states that the risk neutral probability of default is equal to the credit spread (s) divided by the percentage loss on default

Question 4

Price of credit risk

Answer 4

B(0,1) = (K / 1+r)(λ*R+(1-λ))