FMI: Topic 3: CREDIT RISK

What is credit risk?

When risk arises from failure of one party to fulfill its financial obligations to the other party

Examples of credit risk

Bankrupcy risk, Downgrade risk, Counterparty risk

Components/ constituents of credit risk?

Probability of default, Exposure at default, Loss given default

What is Probabilty of default(PD)?

The probability of default is the likelyhood of default

What is Exposure at default(EAD)?

Refers to the total value that the bank is exposed to at the time of default

What is Loss given default(LGD)?

This factor determines the losses incurred by the bank when an obligatior defaults

How do we measure credit risk?

Through expected loss(EL)

What is EL

The expected loss from a loan exposure, a loss which exceeds expectations.

How do we calculate EL

PD x EAD x LGD

Why is measuring credit risk hard?

• Key inputs are uncertain

• Financial systems are complex

• Borrowers differ a lot

• Some risks are hidden

• Turning risk into actual loss estimates is difficult

What are some other methods of measuring credit risk?(2)

Qualitative models, credit scoring models

What are benefits of using qualitative models to measure credit risk

They use borrower specific factors such as reputation, leverage and collateral as well as using market specific factors such as the level of interest rates and business cycles

What are credit scoring models?

Involves assigning a numberical score to each borrower based on credit history.

What is the Linear probability model used for?

Credit modelling

Advantages of linear probability models critical evaulation

Simple and intuitive

Limitations of linear probability models critical evaulation

Assumes a linear relationship between independent variables and probability of default.

What is the Logit and Probit model?

Binary response models where the coefficents of the independent variables represent the change in the log- odds of the probability default.

What is the Linear discriminant model(LDA)?

Statistical technique that is commonly used in credit modelling to predict the PD, often used to develop credit scoring models.

Advantages of the linear discriminant model?

Simple and easy, linear and well established

Limitations of the linear discriminant model

Assumes that the distribution of borrower charactaristics are normal, and LDA can be sensitive to outliers

What are credit derivatives

Financial instruments that transfer credit risk of an underlying portfolio of securities from one party to another without transferring the underlying portfolio.

Charactaristics of credit derivatives

Usually OTC instruments, not bound by regulations.

What is securitisation?

Sale of assets, which generate cash flows, from the institutin that owns them to another company specifically set up for that purpose.

Benefits of securitisation

Helps banks diversity funding mix, reduce costs of funding, reduces credit risk exposure.