Fundamentals of Credit Risk Flashcards
(13 cards)
What is Credit Risk?
It is the probability that one party will lose money if a counterparty fails to honor its financial obligation due to either:
- an in-ability to repay the obligation
- an un-willingness to repay the obligation
- non-timeliness of honoring the obligation
The party receiving funds
Borrower, obligor, counterparty, and bond issuer
Party providing credit
Lendor, creditor, obligee
How is credit risk assessed?
- Amt of credit risk
- probability of default
- Recovery amount
- Timing of payment receipt
What is insolvency?
A scenario when a company’s liability exceeds its assets (i.e. negative equity)
Insolvent entities are not necessarily bankrupt.
What is default?
Counterparty fails to meet its obligations
What is bankruptcy?
Legal procedure where an entity, typically in default, seeks legal protection through a court.
Two types of bankruptcy, dissolution/ liquidation and restructuring/ reorganization
Transactions that generate credit risk
Lending, leases, receivables, prepayment, deposits, contingent claims, and derivatives
Institutions that have credit exposure
- Banks, 2. Asset Managers, 3. Hedge funds and pension funds, 4. Insurance companies, 5. Corporations and finally 6. Individuals
How insurance companies are unique in that they have credit exposure?
- Underwriting, 2. Investments and 3. Reinsurance
How do corporations face credit risk?
Through accounts receivables (can be mitigated by buying insurance, selling receivables or using documentary credit)
, short term investments and bank deposits, derivatives, vendor financing and supply chain
Benefits of managing credit risk effectively
Survival, profitability and return on equity
How can credit risk from Accounts receivables be handled?
By buying insurance, selling receivables or using documentary credit
