Credit risk Flashcards
Define credit risk
Credit risk is the risk that a borrower is unable to make the
promised payments
How is credit risk compensated
To compensate you for credit risk the corporate borrowers
with significant default risks pay higher interest rates
what is the S&P credit rating system
what is Moody’s rating system
AAA is the best rating; after that comes AA, A, BBB, BB, B,
CCC, CC, and C
Aaa, Aa, A, Baa, Ba, B, Caa, Ca, and C
what credit rating is considered investment grade
BBB or above
how do default probabilities evolve over time
For a company that starts with a good credit rating
default probabilities tend to increase with time
For a company that starts with a poor credit rating default
probabilities tend to decrease with time
define the default intensity
is the probability of default for a certain time period conditional
on no earlier default
also called the hazard rate
define the unconditional default probability
is the probability of default for a certain time period as seen at
time zero
define the recovery rate of a bond
the price of the bond immediately after default as a percent of its
face value
Average default intensity over life of bond is
approximately
S / 1-R
where
* s is the spread of the bond’s yield over the risk-free rate
* R is the recovery rate
Real World vs. Risk-Neutral Default Probabilities
The default probabilities backed out of bond prices or credit default swap spreads are risk-neutral default probabilities
The default probabilities backed out of historical data are
real-world default probabilities
what is a credit score
Quantitative ranking of credit risk
- Main vendors: Credit Ratings Agencies (CRAs);
Typically model-based
Predictive, from 1yr to 5yr horizon
- In some cases, arbitrary ranking (non CRA)
Should we use risk neutral or real world probabilities of default
We should use risk neutral estimates for valuing credit derivatives and estimating the present value of the cost of default
We should use real world estimates for calculating credit VaR
and scenario analysis
what is credit rating
Combine Quantitative and Qualitative Assessments from: Model-based scores amd Expert-based scores
- Approved by Rating Committees
- Approved through Model Validation
- Transparent Methodologies
- Supervised by Regulators
how do we hedge against credit risk
- Portfolio diversification
- Trading in options on stock of the underlying firms
- Using credit derivative
How large is the credit derivatives market
A huge market with over $40 trillion (2007) of notional principal
Single name CDer class
e.g. credit default swaps
market for buyer and seller protection from default
Multi name CDer class
e.g. collateralised debt obligations
portfolio of debt instruments, where its payoffs are channelled to different classes of investors
What is a Credit default swap
contract that provides insurance against the risk of default by a company on its bond obligations
how does a CDS (credit default swap) settlement work
the buyer of the CDS makes periodic payments to the seller until maturity
attractions of the CDS market
Allows credit risks to be traded in the same way as
market risks
Can be used to transfer credit risks to a third party
Can be used to diversify credit risk
Portfolio diversification limits exposure to
Individual borrowers
Sectors
Countries
Risk factors
how do we hedge credit risk using stock and option markets
- Selling stock of the underlying companies short
- Purchasing put options on stock of the underlying companies
Problems: imperfect and expensive hedge
Credit derivatives are financial instruments whose
payoff depends on a credit event:
default
downgrade
spread change
where are credit derivatives traded
OTC
credit derivatives allow us to
Isolate the credit risk component of an asset and hedge against the credit risk or take additional exposure to credit risk
What is the goal of an asset swap
To isolate credit risk from interest rate risk and obtain
fixed credit spread on the underlying bond
advantages of CDS
standardised and fairly liquid
can be marked to market
their price quickly reflects changes in PD
can be used to hedge against spread change
can be used to hedge against specific risk of a borrower
allow to add purely credit risk to the portfolio
goal and benefit of a total return swap
Goal: to take an exposure in the underlying asset without
having to own the asset
benefit: no need for an investor to put cash forward to buy the asset
why do credit spread options have limited popularity
Rather complex to price and hedge
Corporate bonds are rather illiquid, their spreads can be
easily manipulated
Hard to compete with simple and transparent CDSs
goal and complications of Basket Instruments
Goal: Trade credit risk on multiple issuers in one
contract
Complication: default correlations should be taken into
account
Benefits of Credit Derivatives
Allow to isolate credit risk, efficient tool of hedging and managing credit risk
Credit derivatives are more liquid than debt market
Allow to share and transfer the risks
Drawbacks of Credit Derivatives
Complexity of legal issues (Russian Default), difficulties to
determent a payment trigger
Bank regulation complications
Increasing volatility as credit exposure can be sold short
Incentive problems
