credit risk Flashcards
what is credit risk
the risk that occurs when you are owed money and the person might not pay you back
recovery rate if person defaults?
9 to 11 cents on the dollar
what is synthetic insurance?
credit derivatives
what is concentration risk?
contagion, risk that occurs when too much is invested in one industry, no diversification
what is a CDS?
- 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
what is a trigger event?
- 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
what is country risk?
risk of a loss that will occur in the case a country freezes currency payments
what are the credit risks associated with OTC credit derivatives?
presettlement risk = risk that counter party defaults on all or part of its obligation
settlement risk = timing differences between duties performed
what is replacement cost? another name for replacement costs?
cost that would be incurred if counter party completely defaulted on its obligations; part of presettlement risk
another name is market-to-market exposure
what is default probability
probability that the counterparty will not fulfill part or all of their obligation
what is credit exposure
outstanding obligation that would occur if counter party defaulted
what company gives credit ratings? problem with it?
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
methods to reduce credit risk for lender
- risk-based pricing = higher interest rates for companies w/ higher default probability
- covenants = periodic reports that show current financial position of counter party
- credit insurance/derivatives
- tightening = limiting amount of credit to certain parties or setting stricter payment obligations on those companies
- diversification
current trend of credit derivatives market?
up exponentially
2008 value of credit derivatives?
2008 value of credit default swaps?
- 530 trillion
- 55 trillion
when was credit derivatives market developed?
by what company?
by what specific person?
- 1992-1993
- JP morgan chase
- blythe masters
off-balance sheet derivatives vs on-balance sheet derivatives?
off-BS = CDS, TRS on-BS = credit-linked notes, CDOs
dominant financial center for credit derivates?
London
definition of credit derivative?
holder able to separate credit risk from market risk making that credit risk tradeable, hedgeable, transferable
what are digitial derivatives?
cash settled transaction, no delivery of asset is necessary
total return swaps
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
what is the LIBOR rate?
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
what is the credit spread?
two types?
difference in yields between an agreed reference rate and the asset in question
- spread between asset and risk-free instrument
- spread between two different assets
fee determinations for credit derivatives`
- maturity
- credit rating
- counter party
- value of asset after default
