Chapter 19 - Analysis of credit risk

Question 1

Default risk - deemed to have occurred when:

Answer 1

Payment due is missed

Financial ratio falls above or below a certain level

Legal proceedings start against credit issuer

PV of assets falls below PV of liabilities due to economic factors

Question 2

What are the two components of credit risk?

Answer 2

Default risk

Credit spread risk (in market risk too-same)

Question 3

Techniques to manage credit risk

Answer 3

Diversify
Monitor exposure regularly
Take immediate action when default occurs

Question 4

Quantitative credit models

Answer 4

Credit-scoring models
Forecast likelihood of default given ‘fundamental’info about counterparty
Includes empirical and expert models

Structural models
Start with market value of entity
Merton/KMV

Reduced-form models (credit-migration models)
Models mechanism that leads to default as statistical process, which depends on economic variables

Credit portfolio models
Estimate credit exposure across several counter parties

Question 5

Different types of credit portfolio models

Answer 5

Multivariate structural models:
Models asset values (like Merton/KMV), explicit copula to model relationships

Multivariate credit-migration models:
indep log-normal AV, get distribution of portfolio

Econometric and actuarial models:
use economic/empirical data, and not asset values as others

Common shock models:
Bonds default inline with Poisson

Time-until default (or survival) models:
Aims to model incidence of default by using copulas to describe relationships between times of default of bonds in a portfolio

Question 6

Two measures of Recovery:

Answer 6

Price after default (short term measure)

Ultimate recovery (larger than price after default, approx 2 years to be known)

Question 7

What do losses arising from defaults depend on?

Answer 7

SLICER

Seniority
Legal
Industry
Collateral
Economic cycle
Rights of creditors