Chapter 19: Credit risk

Question 1

Credit risk

Answer 1

When a party may default on its obligations

Question 2

Credit event

Answer 2

An event that may trigger a default on a bond

Question 3

recovery rate

Answer 3

The fraction of the defaulted amount that can be recovered through bankruptcy proceedings or some other form of settlement

Question 4

Expected loss

Answer 4

exposure xprobability of default x loss given default
* Loss given default is a percentage, incase there is some recovery through bankrupcy proceedings or other settlement processes

Question 5

Ways in which a company can default

Answer 5

Contracted payment stream:
* is rescheduled
* is cancelled by the payment of an amount which is less than the default-free value of the original contract. - OTP
* continued but at a reduced rate.
* Is totally wiped out. -no recovery

Question 6

Structural models

Answer 6

• Used for companies issuing both shares and bonds, which aim to link default events explicitly to the fortunes of the issuing company.
• Too simple for pricing credit risk
• Difficult to choose the correct model and identify its parameters

Question 7

Reduced-form models

Answer 7

• Statistical models that use observed market statistics such as credit ratings
• Can usually be fitted to the data
• Model how companies move between different models of credit worthiness

Question 8

Intensity-based models

Answer 8

• Particular type of reduced form model

Question 9

The Merton model

Answer 9

• Assumes that the company holds both equities and bonds.
• It is a structural form model.
• The shareholders of the company can be regarded as having a European call option on the fund value with a strike price equal to the bond value.
• The bondholders can be regarded as having cash and short a put European option on the fund value with a strike price equal to the bond value.
• The fund value is typically assumed to follow a geometric brownian motion

Question 10

Expected loss

Answer 10

exposure xprobability of default x loss given default
* Loss given default is a percentage, incase there is some recovery through bankrupcy proceedings or other settlement processes