credit risk

Question 1

what is credit risk

Answer 1

the risk that occurs when you are owed money and the person might not pay you back

Question 2

recovery rate if person defaults?

Answer 2

9 to 11 cents on the dollar

Question 3

what is synthetic insurance?

Answer 3

credit derivatives

Question 4

what is concentration risk?

Answer 4

contagion, risk that occurs when too much is invested in one industry, no diversification

Question 5

what is a CDS?

Answer 5

• credit default swap
• buyer of swap (1st party) makes periodic payments to seller of swap (2nd party)
• in exchange, 2nd party guarantees full payment coverage to 1st party in the case the 3rd party (reference party) defaults on its obligations to the 1st party

Question 6

what is a trigger event?

Answer 6

• event that changes the credit outlook on an asset or entity
• examples: bankruptcy/default, lowering of credit rating, drastic price decrease (materiality threshold), missed payments, change in credit spread

Question 7

what is country risk?

Answer 7

risk of a loss that will occur in the case a country freezes currency payments

Question 8

what are the credit risks associated with OTC credit derivatives?

Answer 8

presettlement risk = risk that counter party defaults on all or part of its obligation
settlement risk = timing differences between duties performed

Question 9

what is replacement cost? another name for replacement costs?

Answer 9

cost that would be incurred if counter party completely defaulted on its obligations; part of presettlement risk
another name is market-to-market exposure

Question 10

what is default probability

Answer 10

probability that the counterparty will not fulfill part or all of their obligation

Question 11

what is credit exposure

Answer 11

outstanding obligation that would occur if counter party defaulted

Question 12

what company gives credit ratings? problem with it?

Answer 12

standards and poors does the credit ratings; problem is that the system is very slow and the credit derivatives market is much better indicator as to whether a company has significant default risk

Question 13

methods to reduce credit risk for lender

Answer 13

1. risk-based pricing = higher interest rates for companies w/ higher default probability
2. covenants = periodic reports that show current financial position of counter party
3. credit insurance/derivatives
4. tightening = limiting amount of credit to certain parties or setting stricter payment obligations on those companies
5. diversification

Question 14

current trend of credit derivatives market?

Answer 14

up exponentially

Question 15

2008 value of credit derivatives?

2008 value of credit default swaps?

Answer 15

• 530 trillion

- 55 trillion

Question 16

when was credit derivatives market developed?
by what company?
by what specific person?

Answer 16

• 1992-1993
• JP morgan chase
• blythe masters

Question 17

off-balance sheet derivatives vs on-balance sheet derivatives?

Answer 17

off-BS = CDS, TRS
on-BS = credit-linked notes, CDOs

Question 18

dominant financial center for credit derivates?

Answer 18

London

Question 19

definition of credit derivative?

Answer 19

holder able to separate credit risk from market risk making that credit risk tradeable, hedgeable, transferable

Question 20

what are digitial derivatives?

Answer 20

cash settled transaction, no delivery of asset is necessary

Question 21

total return swaps

Answer 21

total return payer = energy company that sells credit risk and buys protection

total return receiver = investment bank that buys credit risk and sells protection

energy company pays investment bank total return from reference asset along with any appreciation in that asset

investment bank pays energy company the LIBOR rate + spread which is any depreciation that might occur to the value of the reference asset

energy company retains ownership of the reference asset throughout the entire duration of the swap

Question 22

what is the LIBOR rate?

Answer 22

the interbank borrowing rate which is the rate used by banks when borrowing from one another
the LIBOR rate is used frequently as benchmark for capital market transactions and derivatives

Question 23

what is the credit spread?

two types?

Answer 23

difference in yields between an agreed reference rate and the asset in question

1. spread between asset and risk-free instrument
2. spread between two different assets

Question 24

fee determinations for credit derivatives`

Answer 24

1. maturity
2. credit rating
3. counter party
4. value of asset after default

Question 25

4 reasons to use credit derivatives

Answer 25

1. reduce/manage exposure
2. free up credit lines
3. to avoid exceeding internal limits
4. reduce exposure once limits have been exceeded

Question 26

3 reasons for total returns swaps

Answer 26

1. lock in specified economic value for the duration of the swap
2. transfer market risk off-balance sheet to lower regulatory costs
3. trade credits off-balance sheet

Question 27

relationship between credit spread and default risk

Answer 27

credit spread widens = higher default risk

credit spread narrows = lower default risk

Question 28

easiest way to enter into credit spread transaction? what do they enable?

Answer 28

options; enable trading/hedging of changes in credit quality

Question 29

payoff of credit spread option

Answer 29

payoff = (financial asset - risk free rate - specified strike spread) x (notional dollar amount) x (risk factor)

Question 30

what is risk factor based on

Answer 30

durational/complexity measures

Question 31

what is 50 bps equal to?

Answer 31

50/10,000 = .005

Question 32

first to default basket options? advantage? suited for what?

Answer 32

buyer of option receives notional payout if one company in basket defaults on obligation

advantage is that it is cheaper than individually hedging each asset

suited for investment grade credits with low correlation and low covariances