Handbook of Credit Risk Management, Ch 4: Measurement of Credit Risk

Question 1

State and briefly describe the four important metrics used to quantify the level of credit
risk.

Answer 1

1. Exposure - amount of money at risk
2. Default Probability - likelihood the counterparty will default
3. Recovery Rate - percentage of money relative to the exposure that can be
   recovered in the case of default
4. Tenor - time period in which some or all of the money is outstanding

Question 2

State how to compute GE, NE, and AE

Answer 2

1. Gross Exposure (GE) - represents the amount of money due by the counterparty
   and, therefore, the money at risk in case of bankruptcy
2. Net Exposure (NE) - equal to GE minus the amount of collateral pledged
3. Adjusted Exposure (AE) - equal to NE times the expected usage given default
   (UGD)

Question 3

State the two step process to compute default probabilities.

Answer 3

Two step process to compute PD:
1. Analyze a counterparty’s financial strength and assign a rating to it that
represents its perceived financial strength
2. Using historical data, observe the default frequency of entities with similar ratings.
The observed relative frequency is the estimate of the PD

Question 4

State the major elements that influence the recovery amount

Answer 4

Major elements that influence the amount of recovery:

Amount of assets available

Seniority of the position (i.e. senior creditors typically have greater recoveries)

Security package (e.g. secured creditors with liens)

Question 5

Compare direct vs contingent exposure

Answer 5

The difference between direct and contingent exposure is whether money or
goods have actually been exchanged or if there is just a commitment to do so
Ÿ Direct Exposure: Money/goods have actually been exchanged
Ÿ Contingent Exposure: There is just a commitment to exchange money/goods

Question 6

State how to compute expected loss.

Answer 6

Expected Loss = Exposure Default Probability (1 - Recovery Rate)