Credit and Default Risk

Question 1

What is the ideal bankruptcy code?

Answer 1

Punish strategic defaulters and leave out ‘innocent’ defaulters.

Question 2

Define VaR

Answer 2

What loss level are we X% confident of not exceeding in N business days?

Question 3

Define conditional VaR

Answer 3

Also called Expected Shortfall. Given we have exceeded a certain loss level, what is the expected loss?

Question 4

What are some problems with VaR?

Answer 4

Distributive assumptions
Stability and endogeneity of default
Systemic risk (contagion)

Question 5

What are the key components to Basel I

Answer 5

From 1988.
Reg capital: 8% of Credit Risk Weighted Assets
For loans, CRWA is a weight times principal

Capital either Tier 1 (equity, non-cumulative perpetual preferred stock) or Tier 2 (cumulative perpetual preferred stock, long-term debt)

Question 6

What are the key amendments to Basel I?

Answer 6

1) Netting (in default, all OTC derivatives are onsidered one. Cannot defualt on negative ones and claim the positive ones)
2) Market Risk. Capital requirement for Market Risk (based on VarR)

Question 7

What are the key ideas of Basel II?

Answer 7

1) changes to credit risk (new weights, Internal Ratings Based approach)
2) New capital requirement for Operational risk
3) Requited capital 8% * (cRWA + mRWA + oRWA)
- in some designated mix of tier 1 and tier 2

Question 8

What are the main ideas in Basel 2.5?

Answer 8

Changes to Market Risk (Stressed VaR)

Changes to Credit Risk (Incremental Risk Charge, Comprehensive Risk Measure)

Question 9

What are the main new parts of Basel 3?

Answer 9

Implemented gradually 2013-2019

1) Capital Conservation Buffer (min. retained earnings and dividend distribution triggered by capital ratios)
2) Liquidity Coverage Ratio (for liquidity, not solvency)
3) Counter-cyclical buffer

Question 10

What is an explanation for rating agency ratings?

Answer 10

Moral Hazard. Financed by the companies they rate. It is more transparent now

Question 11

What is a CoCo Bond and why may it be useful for capital structure?

Answer 11

Automatic conversion into equity when a pre-specified threshold is reached. Can be converted in times of financial difficulty. This gives automatic recapitalization

Question 12

What is a typically used risk-free rate estimate in credit analysis?

Answer 12

The LIBOR rate

Question 13

Explain the Merton Model

Answer 13

Model equity as an option on the assets with strike price being the debt. The risk-neutral probability that the firm will default, is the risk-neutral probability that its value is less than the value of debt. Gives number of standard deviations by which the asset value must change for default to be triggered.
Empirically, gives good ranking of default probabilities. So correct monotonic transformation can give default probabilities

Question 14

What are some extensions to the Merton Model?

Answer 14

1) Allowing default to occur when assets fall below a barrier level
2) Allowing for coupon bonds
3) Allowing for liquidation costs in the case of default
4) Allowing for price jumps

Question 15

What is a key assumption behind the Merton Model?

Answer 15

Big assumption is dynamic completeness. But, default means there are risks you can’t insure against

Question 16

What is a key welfare implication of endogenous default?

Answer 16

When default is endogenous, so will asset span be endogenous

Question 17

What are the pros and cons of different bankruptcy codes?

Answer 17

To high a bankruptcy cost and we may have excessive liquidation
Too low bankruptcy costs may however lead to less trade (lower debt capacity)