Chapter 4: Credit Risk Flashcards
What is credit risk at it’s most basic level?
Not being repaid on a loan
What is the party with the financial obligation called?
The obligor
What are the two forms of credit risk?
Counterparty Risk
Issuer Risk
What is the goal of credit risk management?
Maximise risk-adjusted rate of return by maintaining credit risk exposure limits
What is counterparty risk?
The risk that a counterparty fails to fulfil its contractual obligations
What is issuer risk?
The risk that the issuer of a bond could default on its obligations to pay coupons or principal
What is concentration risk?
When a institution has a uneven distribution to individual issuers
What is single-name concentration
Exposure to individual issuer
What is sectorial concentration?
Exposure to a single sector
How can settlement risk occur with FX forwards contracts?
Time zone difference meaning the payments are made at different times.
What is pre-settlement risk?
Where an institution defaults before settlement of the transaction if the transaction has a positive economic value to the other party.
What is an example of pre-settlement risk?
Agreeing to purchase 100 shares at $10. If the price goes to $15 after and the counterparty defaults the buyer is exposed to pre-settlement risk even if no cash has been sent.
What is Systemic Risk?
Breakdown of the entire financial system rather than an individual firm.
What makes systemic risk possible?
Close interlinkages between different parts of the financial system
What is a credit risk boundary issue?
Operational risks to be considered when banks are developing their credit administration areas.
What are the three credit risk boundary issues areas?
1: Internal Processes
2: Systems
3: People
What are the three basic techniques for measuring credit risk?
- Credit Exposure
- Credit Risk Premium
- Credit Ratings
What is credit exposure?
The amount that can potentially be lost if a debtor defaults.
What is potential future exposure?
Estimate of the likely loss at some point in the future
E.g. If debtor defaults and collateral is stock, the value will change
How can potential future exposure be calculated?
Statistical techniques such as VaR
What is credit risk premium?
It’s the difference between the interest rate a firm pays when it borrows and the interest rate on a default-free security such as a government bond.
What is the relationship between credit risk premium and credit ratings?
The higher the credit rating, the lower the chance of default thus a lower credit risk premium.
What did the Basel Accord introduce for credit risk calculation?
A standardised approach for credit rating.
What is a sovereign credit rating?
Take into account overall economic conditions of a country, including political stability.
What are some criticisms of rating agencies?
- Not fast enough
- Conflict of interest
- Possibility of error
What is the Expected Loss Calculation?
EL = PD * EAD * LGD
What is PD?
Probability of Default (%)
What is EAD?
Exposure at Default (Amount)
What is LGD?
Loss Given Default (%)
What is RR?
Recovery rate, 100% - LGD
How much of your loan you can recover in case of default
What is a Credit Event?
No specific definition.
Bankruptcy, insolvency, credit-rating downgrade
What is Wrong Way Risk
Exposure to a counterparty is adversely correlated with the credit quality of that counterparty
What is an example of wrong way risk?
A company using its own stock as collateral on a loan, as risk of the counterparty defaulting decreases so will the value of the collateral.
What is a Non-Performing Asset?
Loans whose repayments are not being made on time. Usually 90 days
What is a credit limit?
Maximum limit for all aspects of credit exposure set by institutions
What are the 4 main limitations of credit risk measurement?
- Using simplified calculations for potential exposure
- Time period not factored - risk of default increases with time exposure
- Diversification not factored in - 20 As may be less risky better than one AAA
- Probabilities are used which are not always accurate
What is an underwriting standard?
Standards that institutions apply to borrowers to evaluate creditworthiness.
What is used when evaluating businesses for underwriting loans?
Financial statements
Earnings
Industry Analysis
Loan terms
What is a Guarantee?
To make a bond more attractive issuers can arrange for another entity to guarantee their loan.
What is a netting agreement?
Combining opposite transactions into one to reduces settlement risk.
What is collateral?
An asset held by the lender on behalf of the obligor, as security for a loan.
What is a Credit Default Swap? CDS
Essentially insurance for a loan. If a bank makes a loan they can pay a premium to a third party who will make them whole if the the loan defaults.
What is a Collateralized Debt Obligation? CDO
ASK CHAT GPT NO IDEA
How can you limit credit exposure to a particular counterparty?
Through CDs, you can mitigate the risk by paying a premium to a third party.
What is a loan sale?
Instead of collecting regular income off a loan a lender can choose to sell the loan to receive a lump sum payment
What is a central counterparty?
Acts as the guarantor of all transactions, protecting members from default.
Acts as a simultaneous counterparty - E.g. CREST
What is a collateral adequacy calculation?
When a short position is taken often collateral is offered for the value of the shares borrowed.
In case of the value of the collateral falling a fee is charged, this fee is based on the volatility of the collateral.
E.g.
If $100 million IBM shares are lent, and government bonds are offered as collateral, how much collateral
should be lodged with the lending firm?
$100m + ($100m x 3%) = $103m
What does a credit risk management function do?
Manages credit risk by
Setting credit policy
Performing credit analysis on counterparty
Assessing risk events
