CREDIT RISK
Allan Cris Ricafort
29 Oct 2022
1st sem, AY 2022-2023
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LEARNING OBJECTIVES
Describe the major sources of credit and
counterparty risk
Identify common methods for managing
credit risk
Explain the basic types of credit
derivatives
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Introduction
Credit risk exists whenever payment or
performance to a contractual agreement by
another organization is expected, and it is
the likelihood of a loss arising from default or
failure of another organization.
Credit risk and the methods used to manage
it depend to a certain extent on the size and
complexity of exposures.
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How Credit Risk Arises?
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How Credit Risk Arises?
Through lending, investing, and credit
granting activities and concerns the return of
borrowed money or the payment for goods
sold
Through the performance of counterparties
in contractual agreements such as
derivatives
Poor economic conditions and high interest
rates contribute to the likelihood of default
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Credit Risk includes:
Default risk
Counterparty pre-settlement risk
Counterparty settlement risk
Legal risk
Sovereign or country risk
Concentration risk
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Default Risk
Traditional credit risk involving default on
payment, typically related to lending or sales.
o A debt issuer is said to be in default when it indicates
it will not make a contractual interest payment to
lenders
Depending on the nature of the lending
agreement, the amount at risk may be as much
as the entire liability
o The likelihood of a recovery depends on several
factors
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Counterparty Pre-Settlement
Risk
Major source of credit risk in financial
markets and arises from exposure to
counterparties in financial derivatives
(swaps, forwards, and options)
Type of credit risk that arise from
transactions with counterparties
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Counterparty Pre-Settlement
Risk
Pre-settlement risk or replacement risk arises from
the possibility of counterparty default once a
contract has been entered into but prior to the
settlement.
o At the time of default, it might be necessary to enter
into a replacement contract at far less favorable
prices.
The risk associated here is that a contract has
unrealized gains and the counterparty’s failure will
result in the loss of that benefit
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Counterparty Settlement Risk
Transaction risk arising from the exchange
of payments between parties to an
agreement
Risk that payment is made but not
received, and it may result in large losses
because the entire payment is potentially
at risk during the settlement process
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Counterparty Settlement Risk
Settlement risk is often associated with foreign
exchange trading, where payments in different
money centers are not made simultaneously and
volumes are huge.
o Counterparties traditionally pay one another in
different currencies, with most transactions settling
one or two days after the trade date.
o There is usually a time delay between an organization
initiating an outbound settlement payment and the
confirmation of the arrival of an inbound payment
from the organization’s trade counterparty.
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Legal Risk
Risk that an organization is not legally
permitted or able to enter into
transactions, particularly derivatives
transactions.
It is necessary to assess the underlying
legal entity with which a contractual
agreement is undertaken.
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Sovereign or Country Risk
Arises from legal, regulatory, and political
exposures in international transactions
When transactions in other countries expose
an organization to the restrictions and
regulations of foreign governments
Even a counterparty or debt issuer with a
high-quality credit rating can become
problematic if the sovereign government
makes it difficult to do business
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Concentration Risk
Affects organizations with exposure that is
poorly diversified by region or sector
o Events or market changes may adversely
affect all in an industry or sector
A bank with a large number of borrowers
in a particular industry sector is vulnerable
to industry concentration risk
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Credit Exposure Management
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Credit Exposure Management
A key credit risk management technique is the reduction of credit exposure.
There is more emphasis on active credit exposure management within
financial institutions
Formalize the credit risk function.
Consider opportunities for credit exposure diversification.
Require settlement and payment techniques that provide certainty.
Deal with high-quality counterparties.
Use collateral where appropriate.
Use netting agreements where possible.
Monitor and limit market value of outstanding [Link] financial
institutions.
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Credit Risk Function
Credit risk management and policy development
may be included in the risk oversight function or, in
larger organizations, as a separate function.
o Setting appropriate credit exposure limits and
monitoring and reporting exposures against limits on
an aggregate, legally enforceable basis
o Collateral and other credit enhancement techniques
o Credit policy methods
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Diversification
Credit committees ensured that credit risk resulting
from banking activities was not excessive
Financial institutions diversified to the extent
possible, within the confines of their regional
businesses and regulatory environment
It may be undesirable from a business perspective
to diversify customers in an attempt to reduce
exposure to the industry, if these customers keep
them in business
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Credit Rationing
Credit is granted where the most
attractive risk-to-return tradeoff is
available
o Higher interest rates are assigned to higher risk
transactions
o Rationing the finite quantity of credit granted
between borrowers with varying credit risk
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Collateral
Derivatives exchanges have used
collateral in the form of margin
o In the event of a subsequent decline in value,
additional margin may be required
Increased use of repurchase transactions
illustrates the usefulness of collateralization
as a risk reduction technique
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Collateral
A repo transaction consists of a sale
transaction and a subsequent
repurchases or purchase-and-resale of
securities
Since title to the securities changes hands,
the lender is effectively granted collateral
over the term of the transaction
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Netting Agreements
Amounts to be exchanged between
counterparties are netted, greatly reducing the
counterparties’ exposure to one another
Bilateral netting agreements between two
financial institutions are done by adding all
payments for a given day and currency pairs,
with only the net payments are paid
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Marking-to-Market
Tool used in conjunction with limits for reducing potential
loss
Outstanding contracts that have large unrealized gains
are monitored closely by periodic marking to market
In the event that a counterparty’s unrealized losses
exceed a predetermined limit, payment from
counterparty with losses can be required to “reset” the
rate on the outstanding contract
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Credit Limits
The use of limits supports and formalizes the principles of
diversification.
Financial institutions involved in trading actively use
position limits to restrict the size of a trading position and
the loss potential.
o Limits for individual traders and trading desks are set based on
experience, performance, risk measurement and modeling, and
the institution’s risk tolerance
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Contingent Actions
Changes to an outstanding contract or agreement
based on the occurrence of certain key events
Such events are specified in a clause to a contractual
agreement and might include the deterioration of a
counterparty’s credit quality, the marked-to-market
value of an outstanding contract exceeding a
predetermined amount, or both
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Other credit risk management
techniques
Secured lending transactions – lending is secured with
assets of value
Credit insurance – receivables insurance provided by a
third party to protect against payment default
Debt covenants – designed to protect creditors and
require a borrower to maintain certain financial
conditions
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Credit Derivatives
Credit Default Swaps
Credit Spread Options
Credit Spread Forwards
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Credit Derivatives
Credit derivatives enable participants to offset risks that
arise as a result of their core business or from an inability
to diversify.
Credit derivatives are contractual agreements based on
credit performance — typically swaps or options. Credit
performance may be based on events such as default,
insolvency or bankruptcy, non-payment of loan
obligations, or downgrading by a rating agency
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Credit Derivatives
Credit derivatives can be classified according to the
type of underlying credit that they are designed to
hedge.
o Sovereign or country risk
o Financial institution risk
o Corporate risk
The terms protection seller and protection buyer are
used commonly to differentiate the perspective of
parties to a credit derivatives transaction.
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30 Advantages of Credit Derivatives
provide a mechanism permitting the transfer of
unwanted risk between willing counterparties, from
organizations with too much credit risk, or the wrong
type of credit risk, to organizations willing to assume it.
allow market participants, especially financial institutions,
to separate credit risk from market risk
provides some additional price transparency to the
business of credit
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Credit Default Swaps
Credit default swap – the protection seller
makes a contingent payment to the protection
buyer if a predetermined credit event occurs.
In exchange for assuming the credit exposure,
the protection seller receives a premium that
may be paid upfront or periodically
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Credit Default Swaps
Credit default swaps specify the contingent
credit event that must occur for compensation
to be made, and therefore, it must be
specifically and unambiguously outlined in the
swap agreement.
o Bankruptcy of the reference entity
o Restructuring of the reference entity
o Failure to pay by the reference entity
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Credit Default Swaps
The underlying reference asset, such as a
particular bond, is referenced in the contract
and may be settled in cash or with delivery of
the underlying reference asset.
o first-to-default basis – credit swaps designed to hedge
a credit portfolio and permits the protection buyer to
receive compensation based on the first default that
occurs in the underlying portfolio.
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Credit Spread Derivatives
based on the interest rate differential between
the debt of different types of issuers
A realized or expected rating change of an
issuer will impact its cost of borrowing compared
with a benchmark rate.
o credit upgrade or improvement will result in the ability
to borrow at lower interest rates
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Credit Spread Derivatives
A credit spread option requires upfront premium in
exchange for protection against (typically) a widening
credit spread between the underlying credit and a
benchmark government yield.
The protection (put) buyer pays premium to the seller
and in return receives a contingent payment if the
spread widens past a predetermined level.
With a credit spread forward, payment depends on
whether the spread is above or below the contracted
credit spread.
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Other Credit Derivatives
Total return swaps - an exchange of the total return from
an underlying reference asset, such as a bond, against
a predetermined fixed or variable reference rate. The
total return from the asset includes changes in value
arising from market interest rates, changes to the issuer’s
credit rating, and the potential for default.
Credit-linked notes - investor receives par at maturity
unless a predetermined credit event occurs, in which
case the investor receives less than par value
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37 CHALLENGES of Credit Derivatives
Market participants may become more aggressive in
credit and counterparty transactions if they can transfer
credit risks to someone else
Lack of transparency, potential pricing issues, and legal
issues, particularly with cross-border transactions or
reference credits
Credit derivatives spread risk around but don’t actually
reduce it, thus increasing systemic risk
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End of this Module.
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