VRM 6 - MEASURING CREDIT RISK Flashcards
What is the primary goal of evaluating a bank’s economic capital?
To assess its level of credit risk.
Economic capital is an internal measure that reflects the amount of capital a bank needs to cover its risks.
What is the difference between economic capital and regulatory capital?
Economic capital is a bank’s own estimate of required capital, while regulatory capital is determined by regulatory requirements.
Regulatory capital calculations are standardized, whereas economic capital considers correlations between different risks.
Name three important factors used to calculate economic capital for credit risk.
- Probability of default
- Exposure
- Loss rate
These factors help in estimating the potential losses a bank may face.
How is expected loss (EL) defined?
EL is the average loss a bank anticipates from its loan portfolio.
It can be calculated using the formula EL = PD × LGD or EL = PD × (1 — RR).
What does unexpected loss (UL) refer to?
UL is the loss that exceeds the expected loss over a given time period.
It represents the risk that actual losses may be significantly higher than anticipated.
How can the mean and standard deviation of credit losses be estimated?
By assuming a binomial distribution for loan defaults.
This approach models the probability of defaults occurring over a specified period.
What does the Gaussian copula model help to analyze?
It helps in modeling the joint distribution of credit risks.
The model is used to assess correlated risks in financial portfolios.
What is the purpose of the Vasicek model?
To estimate default rates and credit risk capital for banks.
It relates the probability of default to economic factors.
What is the CreditMetrics model used for?
It is used to estimate economic capital for credit risk.
This model accounts for potential losses from credit rating downgrades and defaults.
What does Euler’s theorem help determine in the context of credit risk?
It determines the contribution of a loan to the overall risk of a portfolio.
This theorem is essential for understanding risk allocation in financial portfolios.
True or False: It is easier to calculate credit risk capital for derivatives than for loans.
False
Calculating credit risk for derivatives is more complex due to their intricate structures.
What is credit contagion risk?
The risk that the credit deterioration of one counterparty triggers credit deterioration in others.
It highlights the interconnectedness of financial institutions.
What is the Basel Committee’s role?
To harmonize global banking regulations.
Established in 1974, it sets standards for capital requirements and risk management.
What does the Basel II credit risk regulation include?
- Standardized approach
- Internal ratings-based (IRB) approach
These approaches help banks calculate their required capital for credit risk.
Fill in the blank: The expected loss is calculated as EL = PD × _______.
LGD
LGD stands for Loss Given Default, which is the proportion of the loss a bank expects to incur in the event of default.
What is the significance of a bank maintaining a high credit rating?
It indicates lower default probability and enhances trust with investors and regulators.
A high rating often correlates with lower funding costs.
Why do banks use Monte Carlo simulations in estimating unexpected loss?
To model various scenarios and obtain a probability distribution for default losses.
This method allows for comprehensive risk assessment by simulating different economic conditions.
What is the relationship between the correlation of loans and the standard deviation of portfolio loss?
As correlation increases, the standard deviation of portfolio loss also increases.
This relationship indicates that closely related loans can amplify overall risk.
What does the term ‘going concern capital’ refer to?
Equity capital that supports a bank’s operations while it remains solvent.
It contrasts with ‘gone concern capital,’ which is only relevant when a bank is insolvent.
What is the expected default rate on a bank’s loan portfolio if it is 1.5%?
The expected loss is calculated based on this rate and the recovery rate.
If the recovery rate is 40%, the expected loss can be computed accordingly.
What does the Basel Committee require for regulatory capital in the internal ratings-based approach?
Capital sufficient to cover losses that occur 99.9% of the time.
This is intended to ensure banks can withstand significant losses.
What is the formula for calculating expected loss?
EL = PD × (1 - RR)
Where PD is the probability of default and RR is the recovery rate.
What is an example of a one-factor model?
The capital asset pricing model (CAPM)
In CAPM, the correlation between returns from two stocks is based on a common factor, which is the market index return.
What does the one-factor model assume about the correlation between stock returns?
It arises entirely from their dependence on a common factor
In CAPM, this common factor is the return from the market index.
How does the one-factor model apply to default probabilities?
The factor is related to the economy and affects default rates.
What is the purpose of the Vasicek model?
To determine capital for loan portfolios.
What does the Vasicek model use to define correlation between defaults?
The Gaussian copula model.
What is assumed about the probability of default (PD) in the Vasicek model?
It is the same for all companies in a large portfolio.
In the Vasicek model, when does company 𝑖 default?
If 𝑈𝑖 ≤ 𝑁–1(𝑃𝐷).
What is the inverse cumulative normal distribution used for in the Vasicek model?
To map the binary probability of default distribution for company 𝑖.
What does a high value of factor F indicate in the Vasicek model?
The economy is doing well and defaults are unlikely.
What does a low value of factor F indicate in the Vasicek model?
Defaults are relatively likely.
What is the formula for calculating unexpected loss in the context of Basel II?
𝑈𝐿 = (𝑊𝐶𝐷𝑅 — 𝑃𝐷) × 𝐿𝐺𝐷 × 𝐸𝐴𝐷.
What does WCDR stand for in the Basel II capital requirement?
Worst case default rate.
What does LGD represent in the context of unexpected loss?
Loss given default (equals one minus the recovery rate).
What is the purpose of the Credit Metrics model?
To determine economic capital for banks.
What does a one-year transition table in the Credit Metrics model define?
Changes in credit ratings.
How does the Credit Metrics model calculate credit loss?
As the value of the portfolio at the beginning of the year minus the value at the end of the year.
What is Euler’s theorem used for in risk allocation?
To divide risk measures into their component parts.
What is the significance of homogeneous functions in risk measures?
They are functions that maintain proportionality when scaled.
What is the definition of exposure at default?
The amount the borrower owes at the time of default.
What complicates the calculation of exposure at default for derivatives?
The exposure varies as the value of the derivative changes.
What is the challenge with netting agreements in derivatives?
All outstanding derivatives may be treated as a single derivative upon counterparty default.
What is the difference between through-the-cycle PD and point-in-time PD?
Through-the-cycle PD is an average over an economic cycle, while point-in-time PD reflects current conditions.
What is the relationship between recovery rate and default rate?
They are negatively correlated.
What type of risk is associated with the situation where a counterparty is more likely to default when the value of derivatives is negative to a company?
Wrong-way risk.
What are the other risks that banks must manage alongside credit risk?
- Market risk
- Operational risk
- Liquidity risk
- Strategic risk
True or False: The Gaussian copula model guarantees accurate estimates of loan losses in extreme scenarios.
False.
