VRM6 - Measuring Credit Risk

Question 1

Describe how economic capital is derived

Answer 1

Banks tend to be more conservative than regulators require, regulators require capital that will take a 1 in 1000 year loss

Question 2

Describe degree of dependence typically observed among the loan defaults in a bank’s loan portfolio, and explain the implications for the portfolio’s default rate

Answer 2

Tend to be good or bad years for default rate as defaults are not independent of each other due to economic conditions

More defaults = higher default rate

Question 3

Define and calculate the expected loss

Answer 3

E(Loss_i) = p_i * L_i * (1 - R_i)

pi is prob of default
Li is amount borrowed
Ri is recovery rate

Question 4

Define and explain unexpected loss

Answer 4

Worst-case financial loss from an event, requires monte carlo simulation to find

Question 5

Estimate mean and standard deviation of credit losses assuming a binomial distribution

Answer 5

mean = np
var = npq

Question 6

Describe the Gaussian copula model and its application

Answer 6

Assume joint distribution between two random variables is bivariate normal so long as both individually normally distributed

Question 7

Describe and apply the Vasicek model to estimate default rate and credit risk capital for a bank

Answer 7

Used by regulators to determine capital for loan portfolios

99.9th percentile for default = N((Ninv(Pdefault) - sqrt(rho) * Ninv(0.999)) / sqrt(1 - rho))) <- worst case dafault rate

Credit risk capital requirement = WCDR - Pdef * (1 - R) * exposure at default

Question 8

Describe the CreditMetrics model and explain how it is applied in estimating economic capital

Answer 8

Used to determine economic surplus

Each borrower given credit rating from internal or external model with transition matrix, monte carlo sim how ratings change over a year and revalue portfolio at the end of the year

Question 9

Describe and use Euler’s theorem to determine the contribution of a loan to the overall risk of a portfolio

Answer 9

Theorem divides many risk measures into constituent parts

Change standard deviation of each loan individually by 1% to see the effect of that change on the value of the overall portfolio (i.e. amount of the standard deviation that belongs to each loan)

Question 10

Describe and use Euler’s theorem to determine the contribution of a loan to the overall risk of a portfolio

Answer 10

Theorem divides many risk measures into constituent parts

Change standard deviation of each loan individually by 1% to see the effect of that change on the value of the overall portfolio (i.e. amount of the standard deviation that belongs to each loan)

Question 11

Explain why it is more difficult to calculate credit risk capital for derivatives than for loans

Answer 11

Exposure at default is not as clear with derivatives

Question 12

Describe challenges to quantifying credit risk

Answer 12

Lots of assumptions and estimations need to be made, e.g. recovery rate, exposure at default, probability of default