Zvi Wiener

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Financial Risk Management

• Zvi Wiener
• Following
• P. Jorion, Financial Risk Manager Handbook

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Chapter 18Introduction to Credit Risk

• Following P. Jorion 2001
• Financial Risk Manager Handbook

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Credit Risk

• Risk of an economic loss from the failure of a
  counterparty to fulfill its contract obligations.
• This type of risk can take various forms failure
  to pay, settlement risk, covenants, credit
  derivatives, etc.

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Settlement Risk

• Herstatt Bank failure 1974
• March 1996, BIS report on settlement risk in FX
  market (gt1T/day), see
• www.bis.org/publ/cpss17.pdf
• Committee on Payment and Settlement Systems
• CLS, Target, netting, systemic risk.
• Real time gross settlement RTGS
• Continuous linked settlement CLS bank (1998)

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Status of Trade

• Revocable can be canceled
• Irrevocable - after the payment was sent but
  before the counter payment is due
• Uncertain after the payment from counterparty
  is due but before it is received
• Settled after the counterparty payment has
  been received.
• Failed after it has been established that the
  counterparty has not made the payment.

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Drivers of Credit Risk

• Default
• Credit exposure (EAD exposure at default)
• Loss given default (LGD), fractional recovery

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RM tools

• Notional amount
• Risk-weighted amounts
• External/internal credit ratings
• Internal portfolio credit models

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Credit Losses

• bi is 1 if default occurs, 0 otherwise
• CE credit exposure at the time of default
• f recovery rate, (1-f) LGD

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Joint Events
10
Example
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FRM-00, Question 46

• An investor holds a portfolio of 50M. It
  consists of A-rated bonds (20M) and BBB-rated
  bonds (30M).Assume that the one-year
  probabilities of default are 2 and 4
  respectively and are independent. The recovery
  rate for A-bond is 60 and recovery rate for
  BBB-bond is 40. What is the one-year expected
  credit loss of this portfolio?
• A. 672,000
• B. 742,000
• C. 880,000
• D. 923,000

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FRM-00, Question 46

• An investor holds a portfolio of 50M. It
  consists of A-rated bonds (20M) and BBB-rated
  bonds (30M).Assume that the one-year
  probabilities of default are 2 and 4
  respectively and are independent. The recovery
  rate for A-bond is 60 and recovery rate for
  BBB-bond is 40. What is the one-year expected
  credit loss of this portfolio?
• A. 672,000
• B. 742,000
• C. 880,000 20?0.02(1-0.6)30?0.04(1-0.4)
• D. 923,000

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FRM-98, Question 42

• A German Bank lends 100M DEM to a Russian bank
  for one year and receives 120M DEM worth of
  Russian government securities as collateral.
  Assuming that the 1-year 99 VaR on the Russian
  government securities is 20M DEM and the Russian
  banks 1-year probability of default is 5, what
  is the German banks probability of losing money
  on thios trade over the next year?
• A. Less than 0.05
• B. Approximately 0.05
• C. Between 0.05 and 5
• D. Greater than 5

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FRM-98, Question 42

• A German Bank lends 100M DEM to a Russian bank
  for one year and receives 120M DEM worth of
  Russian government securities as collateral.
  Assuming that the 1-year 99 VaR on the Russian
  government securities is 20M DEM and the Russian
  banks 1-year probability of default is 5, what
  is the German banks probability of losing money
  on this trade over the next year?
• A. Less than 0.05
• B. Approximately 0.05
• C. Between 0.05 and 5, it is exactly 5
• D. Greater than 5

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Credit Risk Diversification

• Single loan of 100M, with probability of default
  1 and 0 recovery. The expected loss and st. dev
  are
• EL 1?100M 1M, SD 10M
• Consider 10 loans, each for 10M. The total
  notional is 100M. Assume that defaults are
  independent with probability 1 and 0 recovery
• EL 10 ?1 ?10 1M, SD 3M

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More Examples