Financial Risk Management
Credit Risk
Following P. Jorion, Financial Risk Management Chapter 18
Daniel HERLEMONT
Introduction Credit risk can be broadly defined as the risk of financial loss due to counterparty failure to perform obligations Credit risk is far more important than market risk Time and lack of diversification has been the primary reason for bank failure. It is only recently that banking industry have learned to measure credit risk in the context of portfolio : that is VAR ... Once measured credit risk can be managed and diversified like any other financial risk. Banking sector is busily developing sophisticated internal models for credit risk Daniel HERLEMONT
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Challenges Credit risk is much more difficult to quantify than market risk There are many more factors driving risks, some are extremely difficult to measure due to their infrequency. credit risk model suffer from a verification problem. Unlike market risk for which backtesting can be performed on a daily basis, the longer horizon of credit risk model makes difficult to compare risk forecast with realization. Nevertheless some progress have been accomplished Credit risk is an active field of research Daniel HERLEMONT
Contents Settlement risk during a short window Components of credit risk system and the evolution of credit risk measurement systems How to construct the distribution of credit loss for a portfolio Correlations effect How to manage credit risk Basle II for credit risk Daniel HERLEMONT
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Settlement Risk Pre-settlement risk is the risk of loss due to the counterparty's failure to perform on an obligation during the lifetime of the transaction default on loan or bond failure to make the required payment on a derivative can exist over a long periods, often years
Settlement risk is due to exchange of cash flows is much shorter term failure to perform on settlement can be caused by counterparty default, liquidity constraints or operational problems Daniel HERLEMONT
Settlement Risk Herstatt Bank failure 1974 March 1996, BIS report on settlement risk in FX market (>$1T/day), see www.bis.org/publ/cpss17.pdf Committee on Payment and Settlement Systems CLS, Target, netting, systemic risk. Real time gross settlement = RTGS Continuous linked settlement = CLS bank (1998) Daniel HERLEMONT
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Settlement Risk Status of a trade Revocable – can be canceled Irrevocable - after the payment was sent but before the counter payment is due Uncertain – after the payment from counterparty is due but before it is received Settled – after the counterparty payment has been received. Failed – after it has been established that the counterparty has not made the payment.
Settlement Risk can occur during periods of irrevocable and uncertain status Managed by Real Time Gross Settlement (RTGS) systems Netting Systems Daniel HERLEMONT
Settlement Risk - FRM questions
Daniel HERLEMONT
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Drivers of credit risk Credit risk measurement systems attempt to quantify the risk of losses due to counter party default The distribution of credit risk can be viewed as a compound process driven by: Default which is a discrete state for the counterparty Credit Exposure also known as Exposure At Default (EAD) which is the economic value of the claim on the counterparty at the time of default Loss Given Default (LGD) which represent the fractional loss due to default LGD = 1 - recovery rate
Daniel HERLEMONT
Credit Risk Measurement Tools - steps Notional amount say 8% of the notional amount was applied to establish the amount of required capital to face credit risk problem: this approach ignores the probability of default
Risk-weighted amounts in 1998 the Basle Committee defined a rough credit risk classes and to apply different weights according to the classes was too simple, creating an incentive to shift toward bad quality loans or bonds (e.g. there are no difference between AAA and C corporate credits)
External/internal credit ratings 2001 Basle Committee proposed that bank uses their own Internal Rating Based (IRB) system more in line to economic measures
Internal portfolio credit models However, the IRB approach is still a stand alone approach, withoutt considering correlation effects This harks back to the age of finance before the benefits of diversification were formalized by Markowitz !!! Daniel HERLEMONT
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Credit Risk vs Market Risk
Daniel HERLEMONT
Credit vs Market returns
Frequency
Typical credit returns
Typical market returns
Source: CIBC
Portfolio Value
Credit return are highly skewed and fat tailed Daniel HERLEMONT
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Measuring Credit Risk - Credit Losses
N
CreditLoss = ∑ bi ⋅ CEi ⋅ (1 − f i ) i =1
bi is 1 if default occurs, 0 otherwise CE = credit exposure at the time of default f = recovery rate, (1-f) = LGD N
E [CL] = ∑ pi ⋅ CEi ⋅ (1 − f i ) i =1 Daniel HERLEMONT
Joint Events
Daniel HERLEMONT
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FRM-00, Question 46 An investor holds a portfolio of $50M. It consists of A-rated bonds ($20M) and BBB-rated bonds ($30M).Assume that the one-year probabilities of default are 2% and 4% respectively and are independent. The recovery rate for A-bond is 60% and recovery rate for BBB-bond is 40%. What is the one-year expected credit loss of this portfolio?
A. $672,000 B. $742,000 C. $880,000 D. $923,000 Daniel HERLEMONT
FRM-98, Question 42 A German Bank lends 100M DEM to a Russian bank for one year and receives 120M DEM worth of Russian government securities as collateral. Assuming that the 1-year 99% VaR on the Russian government securities is 20M DEM and the Russian bank’s 1-year probability of default is 5%, what is the German bank’s probability of losing money on thios trade over the next year?
A. Less than 0.05% B. Approximately 0.05% C. Between 0.05% and 5% D. Greater than 5% Daniel HERLEMONT
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Credit Risk Diversification Single loan of $100M, with probability of default 1% and 0 recovery. The expected loss and st. dev are: EL = 1%× ×$100M = $1M,
SD = $10M
Consider 10 loans, each for $10M. The total notional is $100M. Assume that defaults are independent with probability 1% and 0 recovery: EL = 10 ×1% ×10 = $1M,
SD = $3M
Daniel HERLEMONT
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