QFIP-157: QERM, Ch 12 - Credit Risk Flashcards
State the main strategies for mitigating credit risk in traditional lending
Evaluating the ability and willingness of the borrower to repay
Collateral
Covenants
Define counterparty credit risk (CCR) and state the features of CCR
Counterparty credit risk (CCR) - possible losses that may be incurred when a
counterparty to an over-the-counter contract fails to honor its obligations
Features of counterparty credit risk:
Bilateral
Stochastic
State the risk mitigation techniques to reduce the impact of counterparty credit risk
Risk mitigation techniques to reduce the impact of counterparty credit risk:
Netting
Collateral
Establishment of central counterparties (CCPs) - institutions that act much like
exchanges for standardized and commonly traded OTC derivatives
State the formulas for “exposure with netting” and “exposure without netting” for a
portfolio
Exposure without Netting
¸N
j1
maxpVj , 0q
Exposure with Netting maxp
¸N
j1
Vj , 0q
Compare default vs mark-to-market losses
Two types of credit losses:
Default losses - losses that result from an actual default event
Mark-to-market losses - decreases in the current value of a credit-sensitive
portfolio owing to fluctuations in market factors
About 1/3 of CCR losses in the 2007-8 financial crisis were from default losses,
2/3 were from mark-to-market losses
Describe the three basic components of a model of credit risk
- Probability of default - assesses the likelihood that the obligor will default over a
given horizon - Exposure at default - measures the maximum possible loss if default occurs
- Loss given default - percentage of the exposure that is lost when a default takes
place
Note: Compare this to the first flashcard from HCRM Ch 4, which has many similarities
with this flashcard. HCRM explicitly adds tenor as a fourth metric.
Define wrong-way risk and right-way risk
Wrong-way risk - existence of a positive correlation between default frequency
and losses given default
Right-way risk - negative correlation between default rates and losses given
default
Define momentum and stickiness of credit ratings
Momentum - credit rating transitions exhibit a tendency to continue moving in the
same direction
Stickiness - securities show a tendency to persist in a given rating class if they
have been in that class for a long time
Briefly compare structural vs reduced form models
Structural models - attempts to model the underlying process that generates
defaults
Reduced form models - tries to replicate the empirical properties of default
behavior without any attempt to incorporate underlying causes or events
State how to compute the value of shareholders equity using the Merton model
Where we have that:
d1,t
ln
At
L
pr
12
2qpTtq
?
Tt
d2,t d1,t
?
T t
Note that denotes the standard normal CDF, which can be calculated using
NORM.S.DIST in Excel
State how to compute the real-world and risk-neutral probabilities of default using the
Merton model
Real-world probability of default, given the information available at time 0:
PrP
pAT Lq
ln
L
A0
1
22
T
?
T
Risk-neutral probability of default, given the information available at time 0:
PrQ
pAT Lq
ln
L
A0
r
1
22
T
?
T
State how to compute the probability of default when using a reduced form model,
assuming a Poisson process is used with deterministic intensity parameter ptq
Poisson process with intensity gives:
Prp ¤ tq 1 expptq
More generally, for a Poisson process with intensity that varies deterministically
over time:
Prp ¤ tq 1 expp
» t
0
psq dsq
Briefly describe the model form of a single factor Gaussian copula used to model credit
risk
Can use a single factor Gaussian copula with a systematic and idiosyncratic
component (similar to CAPM):
Yn n Z
b
1 2n
n
Notation
Z and n are iid N(0,1)
Z is the systematic risk factor, reflecting the performance of the overall economy
n captures the idiosyncratic risk for firm n
Yn are N(0,1), but dependent because they depend on the same value Z
Called the “creditworthiness index” of firm n
Default occurs if Yn ¤ Hn
