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CISI: Risk > Chapter 4: Credit Risk > Flashcards

Chapter 4: Credit Risk Flashcards

1
Q

What is credit risk at it’s most basic level?

A

Not being repaid on a loan

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2
Q

What is the party with the financial obligation called?

A

The obligor

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2
Q

What are the two forms of credit risk?

A

Counterparty Risk
Issuer Risk

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3
Q

What is the goal of credit risk management?

A

Maximise risk-adjusted rate of return by maintaining credit risk exposure limits

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4
Q

What is counterparty risk?

A

The risk that a counterparty fails to fulfil its contractual obligations

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5
Q

What is issuer risk?

A

The risk that the issuer of a bond could default on its obligations to pay coupons or principal

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6
Q

What is concentration risk?

A

When a institution has a uneven distribution to individual issuers

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7
Q

What is single-name concentration

A

Exposure to individual issuer

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8
Q

What is sectorial concentration?

A

Exposure to a single sector

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9
Q

How can settlement risk occur with FX forwards contracts?

A

Time zone difference meaning the payments are made at different times.

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10
Q

What is pre-settlement risk?

A

Where an institution defaults before settlement of the transaction if the transaction has a positive economic value to the other party.

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11
Q

What is an example of pre-settlement risk?

A

Agreeing to purchase 100 shares at $10. If the price goes to $15 after and the counterparty defaults the buyer is exposed to pre-settlement risk even if no cash has been sent.

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12
Q

What is Systemic Risk?

A

Breakdown of the entire financial system rather than an individual firm.

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13
Q

What makes systemic risk possible?

A

Close interlinkages between different parts of the financial system

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14
Q

What is a credit risk boundary issue?

A

Operational risks to be considered when banks are developing their credit administration areas.

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15
Q

What are the three credit risk boundary issues areas?

A

1: Internal Processes
2: Systems
3: People

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16
Q

What are the three basic techniques for measuring credit risk?

A
  1. Credit Exposure
  2. Credit Risk Premium
  3. Credit Ratings
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17
Q

What is credit exposure?

A

The amount that can potentially be lost if a debtor defaults.

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18
Q

What is potential future exposure?

A

Estimate of the likely loss at some point in the future
E.g. If debtor defaults and collateral is stock, the value will change

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19
Q

How can potential future exposure be calculated?

A

Statistical techniques such as VaR

20
Q

What is credit risk premium?

A

It’s the difference between the interest rate a firm pays when it borrows and the interest rate on a default-free security such as a government bond.

21
Q

What is the relationship between credit risk premium and credit ratings?

A

The higher the credit rating, the lower the chance of default thus a lower credit risk premium.

22
Q

What did the Basel Accord introduce for credit risk calculation?

A

A standardised approach for credit rating.

23
Q

What is a sovereign credit rating?

A

Take into account overall economic conditions of a country, including political stability.

24
Q

What are some criticisms of rating agencies?

A
  1. Not fast enough
  2. Conflict of interest
  3. Possibility of error
25
Q

What is the Expected Loss Calculation?

A

EL = PD * EAD * LGD

26
Q

What is PD?

A

Probability of Default (%)

27
Q

What is EAD?

A

Exposure at Default (Amount)

28
Q

What is LGD?

A

Loss Given Default (%)

29
Q

What is RR?

A

Recovery rate, 100% - LGD
How much of your loan you can recover in case of default

30
Q

What is a Credit Event?

A

No specific definition.
Bankruptcy, insolvency, credit-rating downgrade

31
Q

What is Wrong Way Risk

A

Exposure to a counterparty is adversely correlated with the credit quality of that counterparty

32
Q

What is an example of wrong way risk?

A

A company using its own stock as collateral on a loan, as risk of the counterparty defaulting decreases so will the value of the collateral.

33
Q

What is a Non-Performing Asset?

A

Loans whose repayments are not being made on time. Usually 90 days

34
Q

What is a credit limit?

A

Maximum limit for all aspects of credit exposure set by institutions

35
Q

What are the 4 main limitations of credit risk measurement?

A
  1. Using simplified calculations for potential exposure
  2. Time period not factored - risk of default increases with time exposure
  3. Diversification not factored in - 20 As may be less risky better than one AAA
  4. Probabilities are used which are not always accurate
36
Q

What is an underwriting standard?

A

Standards that institutions apply to borrowers to evaluate creditworthiness.

37
Q

What is used when evaluating businesses for underwriting loans?

A

Financial statements
Earnings
Industry Analysis
Loan terms

38
Q

What is a Guarantee?

A

To make a bond more attractive issuers can arrange for another entity to guarantee their loan.

39
Q

What is a netting agreement?

A

Combining opposite transactions into one to reduces settlement risk.

40
Q

What is collateral?

A

An asset held by the lender on behalf of the obligor, as security for a loan.

41
Q

What is a Credit Default Swap? CDS

A

Essentially insurance for a loan. If a bank makes a loan they can pay a premium to a third party who will make them whole if the the loan defaults.

42
Q

What is a Collateralized Debt Obligation? CDO

A

ASK CHAT GPT NO IDEA

43
Q

How can you limit credit exposure to a particular counterparty?

A

Through CDs, you can mitigate the risk by paying a premium to a third party.

44
Q

What is a loan sale?

A

Instead of collecting regular income off a loan a lender can choose to sell the loan to receive a lump sum payment

45
Q

What is a central counterparty?

A

Acts as the guarantor of all transactions, protecting members from default.
Acts as a simultaneous counterparty - E.g. CREST

46
Q

What is a collateral adequacy calculation?

A

When a short position is taken often collateral is offered for the value of the shares borrowed.
In case of the value of the collateral falling a fee is charged, this fee is based on the volatility of the collateral.
E.g.
If $100 million IBM shares are lent, and government bonds are offered as collateral, how much collateral
should be lodged with the lending firm?
$100m + ($100m x 3%) = $103m

47
Q

What does a credit risk management function do?

A

Manages credit risk by
Setting credit policy
Performing credit analysis on counterparty
Assessing risk events

CISI: Risk (13 decks)

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