Week 10

Question 1

what are the 3 types of credit risk called?

Answer 1

The first risk is referred to as default risk: is the probability that a borrower defaults—that is, fails to meet its obligation to make full and timely payments of principal and interest, according to the terms of the debt security

The second risk is called credit spread risk
And the third risk is known as downgrade risk

Question 2

what is loss severity? What is it also known as?

Answer 2

Loss severity is in the event of default, the portion of a bond’s value (including unpaid interest) that an investor loses

• Loss severity is also known as loss given default (LGD)

Question 3

What are the Risks in relying on agency ratings

Answer 3

1. Credit ratings can change over time
   Rating transition matrix: is a table constructed by the rating agencies that shows the percentage of issues that were downgraded (including default) or upgraded in a given time period
2. Credit ratings tend to lag the market’s pricing of credit risk
3. Rating agencies may get it wrong: for example, the subprime-backed mortgage securities
4. Some risks are difficult to capture in credit ratings: for example, litigation risk, and environmental risk etc.

Question 4

What are the 4 C’s of credit?

Answer 4

capacity
collateral
covenants
and character

Question 5

Please draw the expected default frequency (EDF) of the Moody’s KMV model. In your plot, please clearly indicate what the EDF is.

Answer 5

please draw