Week 4

Question 1

Credit risk

Answer 1

Risk that obligor doesn’t honour payment obligation

Question 2

Measuring credit risk
PD,EAD,LGD,RE

Answer 2

PD-probability default occurs
EAD- max amount that can be lost when default occurs
LGD-% of exposure to a counterparty
RR- % of exposure recovered on a default

Question 3

Unconditional default probability

Answer 3

Probability of default as seen at time zero

Question 4

Conditional default probability

Answer 4

Probability of default based on the assumption that there has been no earlier default

Question 5

What happens to PD with a good/ bad credit rating

Answer 5

Good- PD rises, bond initially considered creditworthy, overtime will collapse
Bad- PD falls,

Question 6

Quantitive analysis

Answer 6

-Probability, liquidity, solvency ratios (ROA, D/E)
-Credit scoring

Question 7

Qualitative analysis

Answer 7

-Borrower specific factors: reputation, earnings volatility
-Sector specific factors: market position, key trade
-Marker specific factor

Question 8

Bond credit spread

Answer 8

Bond yield- risk free interest rate

Question 9

Credit default swap premium

Answer 9

Cost of credit insurance using CDS

Question 10

Credit Default Swap (CDS)

Answer 10

Gives holder the right to sell bond for its face value (in event of a default by issuer)

Question 11

Describe CDS

Answer 11

-Standard terms, paid in quarterly arrears
-Cash settled
-Cleared through central clearing party (CCP)

Question 12

Basel 2 three types of banks

Answer 12

1.Small- standardised approach
2. Sophisticated- Foundation internal rating
3. Advanced- advanced internal ratings approach