Credit Risk Management Framework (Default Measures (Probability of…
Credit Risk Management Framework
Guarantees will always have a legal edge to them with respect to:
The triggers under which the guarantee will be invoked
The degree of benefit that the guarantee provides and whether there will be any capping or conditionality about this
The form of guarantee and the evidence presented in writing signed by the guarantor
Any special legal defences
The right of the guarantor to seek indemnity and reimbursement
Whether the guarantee is full or only partial – the guarantee of part of a debt might apply to a second tranche of a debt rather like an excess on an insurance policy
Issues w/ guarantees
We will only ever know the real value of a guarantee when we call it up.
the guarantee itself is yet another form of credit risk that may not deliver and hence the legal aspects of guarantees are so vital to get right in their drafting and in the enforceability of the documents.
Risks should be diversified and it has its application therefore in the realms of credit risk; for example lenders will diversify credit risk by taking guarantees and taking collateral.
Another level of diversification is the manner to which it is used to offset risk across a portfolio by spreading it across borrowers or across investments. This has the effect of creating a different set of non-correlating risks and avoids unwanted concentrations of credit risk.
Central Counterparties - Do second part
Listed futures and options markets have always had central clearing houses whereby all the members of an exchange would trade happily with each other knowing that every trade that was conducted between them would be transferred by a legal process known as novation. The process of novation involves a central counterparty clearing house becoming the buyer to every seller and the seller to every buyer.In this way the central counterparty presented a single point of relationship and a single credit risk to every individual member of the exchange rather than the exchange members having risks with each other.
As indicated above, the central counterparties (CCPs) themselves present a credit risk to the firms with whom they have a relationship and in most cases these firms are larger financial entities than the central counterparties themselves. Hence the financial backing and management strength of the central counterparties is vitally important. Typically, this is provided not only by shareholder funds but also a sizeable fund in cash provided by the clearing members of the CCP and possibly by other resources.
Probability of default (PD)
This is the likelihood that a specific asset will go into default. It is a percentage. This is based on the
historic loss experience of the institution.
Loss given default (LGD)
This is the loss that actually occurs when the default event occurs. As such it does take account collateral & the degree of subordination.
Exposure at default (EAD)
The loss is contingent upon the amount to which the bank was exposed to the borrower at the time of default, commonly expressed as exposure at default (EAD).
These three components (PD, LGD, EAD) combine to provide a measure of expected intrinsic, or
is the financial term used to describe a general default event related to a legal entity's previously agreed financial obligation.
Failure to pay
The weighted average cost of capital (WACC) is the rate (expressed as a percentage, as with interest) that a company is expected to pay to bondholders (cost of debt) and shareholders (cost of equity) to finance its assets.
WACC is the minimum return that a company must earn on its existing asset base to satisfy its creditors, owners, and other providers of capital.
Different securities are expected to generate different returns. WACC is calculated taking into account the relative weights of each component of the capital structure – debt and equity, and is used to see if the investment is worthwhile to undertake.