Chapter 7: Credit Risk (Sections 7.1, 7.2, first part of 7.3, 7.4 & 7.5) Flashcards
(8 cards)
What are the two broad approaches to modeling loan defaults?
Reduced-form models treat defaults as random events arriving with a constant intensity (λ), so loans behave like risk-free bonds plus a spread λ covering expected losses. Structural models view a firm’s debt as a risk-free loan minus an option on the firm’s assets—default occurs if asset value falls below debt at maturity.
In reduced-form models, how is the credit spread defined?
The credit spread λ is the extra yield on a loan above the risk-free rate, equal to the default intensity so that the loan’s price equals a risk-free discount at rate r+λ.
What intuition underlies the Merton structural model?
Equity is like a call option on firm assets; if assets < debt at maturity, equity is wiped out and debt holders incur loss—so higher asset volatility and leverage widen credit spreads.
What’s the difference between the Standardized and IRB regulatory approaches to credit risk?
Standardized: regulators assign fixed risk weights to loan categories. Internal Ratings-Based (IRB): banks estimate key parameters—Probability of Default (PD), Exposure at Default (EAD), Loss Given Default (LGD), Maturity (M)—to calculate capital needs; foundational IRB uses bank PD only, advanced IRB internalizes all inputs.
How does the KMV model infer default risk from market data?
It backs out the unobserved firm asset value and volatility by treating equity as a call option on assets; these inputs then determine a “distance to default” mapped to an expected default frequency.
What is the CreditMetrics approach to portfolio credit risk?
It uses a credit-rating transition matrix to project how obligors migrate between ratings over time, constructing a loss distribution for expected and unexpected credit losses.
What distinguishes CreditRisk+ from other models?
It’s a reduced-form, Poisson-based portfolio model that computes loss distributions solely from default rate parameters and exposures, without relying on asset-value dynamics.
How does CreditPortfolioView forecast portfolio risk?
It employs logistic regression on macroeconomic variables to model transitions in obligor credit ratings and derive forward-looking loss distributions.
