Chapter 16 - Credit Risk

Question 1

What is the formula for expected credit loss?

Answer 1

ECL = exposure x prob of default x loss given default

Question 2

What is a provision?

Answer 2

Expected Credit Loss but you may need to discount

Question 3

Define a structural model to model credit risk.

Question 4

What is a Structural Credit Risk model?

Answer 4

A Structural model represent the firms assets and liability’s and define a mechanism for default i.e. focuses on the firms financial structure An example: Merton Model

Question 5

What is a Reduced-form Credit Risk model?

Answer 5

Reduced-form models are statistical models that use observed data, both macro and micro, and so can usually be ‘fitted’ to data.

Default is no longer tied to the firm value falling below a threshold-level, as in structural models. Rather, default occurs according to some exogenous hazard rate process.

Question 6

Define the Merton Model.

Answer 6

F(T) = B(T) + E(T)

F(T) - Firms value
B(T) - Firms Debt
E(T) - Firms Equity

Question 7

What is the Equity of a firm using the Merton Model?

Answer 7

E(T) = Max{F(T) - L,0)

L - liabilities

This can be seen as a call option with Strike Price L and S(t) = F(t)

Question 8

Describe a two-state model for Credit Risk

Answer 8

We use state models with two states; No default (N) and Default (D) with transition intensities lambda(t)

Question 9

What is the formula to calculate the probability for a firm who is in state N (No default) at time t and remains in State N until time T.

Answer 9

Q(X(T)=N|X(t)=N) = exp( -int[t,T)lambda(s) ds)