VRM4 - External and Internal Credit Ratings

Question 1

Define external rating scales, the rating process, and the link between ratings and default

Answer 1

External credit rating is attribute of an instrument, attributed by an entity

Lower rating means higher probability of default

Question 2

Define conditional and unconditional default probabilities and explain the difference between the two

Answer 2

Unconditional is probability of default at time n. Conditional is probability of default at time n+1 given survival to n

Question 3

Define and use the hazard rate to calculate the unconditional default probability of a credit asset

Answer 3

P default = 1 - exp(h*t)

Question 4

Define recovery rate and calculate expected loss from a loan

Answer 4

Value of a bond shortly after default, % of face value

Expected loss = P default * (1 - recovery rate)

Question 5

Explain and compare the through-the-cycle and point-in-time internal ratings approaches

Answer 5

Through the cycle tries to capture average credit worthiness of firm over years, point in time is best estimate of future default probabilities

Question 6

Describe alternative methods to credit ratings produced by rating agencies

Answer 6

Alternative is to use a model produced by a bank or something, which can take into account a range of factors about a firm