Handbook of Credit Risk Management, Ch 1: Fundamentals of Credit Risk

Question 1

Define credit risk

Answer 1

Credit risk - the possibility of losing money due to the inability, unwillingness, or
nontimeliness of a counterparty to honor a financial obligation

Question 2

Define obligor

Answer 2

Obligor - counterparties that have the responsibility of making good on an obligation

Question 3

Define insolvency

Answer 3

Insolvency - financial state of an obligor whose liabilities exceed its assets

Question 4

Define default

Answer 4

Default - failure to meet a contractual obligation, such as through nonpayment

Question 5

Define bankruptcy

Answer 5

Bankruptcy - occurs when a court steps in upon default after a company files for
protection under either Chapter 11 or Chapter 7 of the bankruptcy laws (in the United
States)

Question 6

State the main sources of credit risk typically most associated with each of the entities
below:

Banks

Insurance Companies

Corporations

Answer 6

Banks: Loans, lines of credit

Insurance Companies: Underwriting activities, Investment portfolio, reinsurance
receivables/recoverables

Corporations: AR, investments, derivatives, equipment leases, supply chain

Question 7

State three ways to manage AR credit risk

Answer 7

1. Buy insurance on receivables
2. Sell receivables to “factoring companies”
   Ÿ Factoring companies purchase AR from clients at a small discount. The client gets
   immediate funds for the receivable
3. “Documentary credit”
   Ÿ Similar to a letter of credit
   Ÿ Organizes an international trade mechanism to provide an economic guarantee of
   payment from a creditworthy bank

Question 8

State three reasons to manage credit risk

Answer 8

1. Survival - firms should proactively understand their large potential losses and
   manage risk appropriately to minimize the risk of bankruptcy
2. Profitability - the less money a company loses from credit events, the more
   money it makes
3. Return on Equity (ROE)
   Ÿ Sufficiently large equity base should be built to survive large and unexpected losses
   Ÿ However, at the same time, holding too much equity capital reduces return on equity
   Ÿ Firms should hold adequate equity capital and complement with prudent risk
   management
   Ÿ Actively managing a credit portfolio can help increase the company’s return on equity