Credit risk
Contents
• Credit risk
• Credit instruments
• Credit risk: estimating default probabilities
Credit risk
Definition:
Credit risk is the possibility that a borrower or counterparty will fail
to meet their obligations in accordance with agreed terms.
Credit risk is the risk of an economic loss from the failure of a
counterparty to fulfill its contractual obligations. Its effects is
measured by the cost of replacing cash flow if the other party default.
Pre-settlement risk and settlement risk
Counterparty credit risk consist of both pre-settlement and
settlement risk.
Pre-settlement risk is the risk of loss due to the counterparty’s
failure to perform on an obligation during the life of the transaction.
This includes default on a loan or bond or failure to make the
required payment on a derivative transaction.
Pre-settlement risk exists over long periods--years—starting from the
time it is contracted until settlement.
Settlement Risk
In contrast, settlement risk is due to the exchange of cash flows and is
of a much shorter-term nature. This risk arises as soon as an
institution makes the required payment and exists until the offsetting
payment is received. This risk is greatest when payment occur in
different time zones, especially for foreign exchange transactions
where notionals are exchanged in different currencies.
Failure to perform on settlement can be caused by counterparty
default, liquidity constraints, or operational problems.
Drivers of credit risk
• Credit risk measurement system attempt to quantify the risk of losses due to
counterparty default. The distribution of credit risk can be viewed as a compound
process driven by these variables:
• Default, which is a discrete state for the counterparty--either the counterparty is
in default or not. This occurs with some probability of default (PD).
• Credit exposure, which is the economic or market value of the claim on the
counterparty. It is also called exposure to default (EAD) at the time of default.
• Loss given default (LGD), which represents the fractional loss due to default. As
an example, take a situation where default results in a fractional recovery rate of
30% only. LGD is then 70% of the exposure.
Measurement of credit risk
The evolution of credit risk measurement tools has gone through these
four steps:
1) Notional amounts adding up simple exposures
2) Risk-weighted amounts, adding up exposure with a rough adjustment of risk
3) Notional amounts combined with credit rating, adding up exposure adjusted
for default probabilities.
4) Internal portfolio credit models, integrating all dimensions of credit risk
Initially, risk measures were based on the total notional amount. A multiplier, say
8%, was applied to this amount to establish the amount of required capital to hold
as a reserve against credit risk.
The problem of this approach is that it ignores variations in the probability of
default. In 1988, the Basel Committee instituted a rough categorization of credit
risk by risk class.
Comparison of market risk and credit risk
Measuring credit risk
• Credit losses
• To develop the intuition of credit models, let us start with a simple case
where losses are due to the effects of default only. This is what is called
default mode.
• The distribution of credit losses (CLs) from a portfolio of instruments issues
by different obligors can be described as:
• Where
• is Bernoulli distribution random variables that takes the value of 1 if default
occurs and 0 otherwise, with probabilities such that
• = the credit exposure at time of default
• = the recovery rate, or the loss given default.
Example of credit risk
• You have granted an unsecured loan to a company. This loan will
be paid off by a single payment of $50 million. The company has
a 3% change of defaulting over the life of the transaction and
your calculations indicate that if it defaults you would recover
70% of your loan form the bankruptcy courts. If you are required
to hold a credit reserve equal to your expected credit loss, how
great reserve should be?
Resources
• Chapter 19: Introduction to credit risk, PHILIPPE JORION GARP