Summary - Credit Risk Flashcards
Credit Risk
- explanation
Credit risk is the risk of financial loss due to a counterparty’s failure to meet its obligations —
either through default,
credit downgrade,
or credit spread widening.
It affects loans, bonds, derivatives (via counterparties), and even reinsurance arrangements.
Credit Risk
- Risk Controls (8)
Credit limits: Caps on exposures by counterparty, sector, or rating.
Credit ratings & internal scoring: For assessing and monitoring counterparties.
Collateral & margining: To reduce potential loss on default.
Credit derivatives: Like CDS (Credit Default Swaps) to transfer credit risk.
Diversification: Across counterparties, sectors, and geographies.
Netting agreements: Especially in derivative contracts (ISDA).
Monitoring and early warning signals: E.g. watchlists, downgrade triggers.
Due diligence and covenant protections: Especially in direct lending.
Credit Risk
- Unique factors (6)
Wrong-way risk / tail dependence: Where credit exposure and probability of default rise together (e.g. a CDS on a bank during a banking crisis).
Concentration risk: Hidden correlations (e.g. banks all exposed to same property sector).
Contagion effects: Defaults can have ripple effects across interconnected entities.
Illiquidity of distressed credit instruments.
Model limitations: Credit migration and default models are heavily assumption-driven.
Pro-cyclicality of credit risk: Defaults spike in downturns, when buffers are weakest.
Credit Risk
- ACRONYM
CREDIT MAP
C – Collateral:
Secured assets to cover counterparty failure.
R – Ratings & reviews:
Assess creditworthiness using internal/external scores.
E – Early warning signs:
Triggers that suggest rising credit risk.
D – Diversification:
Spread exposure across sectors and entities.
I – ISDA/netting:
Legal frameworks to reduce counterparty risk.
T – Trigger monitoring:
Watch downgrade thresholds and credit events.
M – Margining:
Post collateral as exposure changes.
A – Analysis & due diligence:
Investigate creditworthiness before transacting.
P – Portfolio limits:
Cap total exposure to avoid concentration risk.
