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chapter 4 : measure of credit risk, Chapter 5: dynamic credit exposure,…
chapter 4 : measure of credit risk
three concepts to set exposure numbers
NE
AE
GE
default probability
calculate steps
analyze financial strength and assign a rating to it
using historical data and observe the default frequency of entities with similar rating
expected usage given default
UGD captures the expected rate of utilization of a facility in case of bankruptcy
drawback of using historical data
default frequency is not stable across economic cycles
default probability increases with time
rating agencies do not provide information for small companies
recovery rate
the amount of money relative to the exposure that can be recovered in case of default
three ways to impact- loss given default
the seniority of claims: senior, junior
Collateral /security: unsecured,secured
value of underlying assets at the time of default
loss given default= 1- recovery rate
measurement of analyze credit exposure
default probability
recovery rate
exposure
tenor
Chapter 5: dynamic credit exposure
common families of transaction generating dynamic credit exposure
derivative contract
repo transactions
long-term sale or supply contracts
what is VAR
definition
an estimation of expected maximum credit exposure of an entity within a specific confidence level and time horizon
impact of VAR
higher confidence interval, higher estimated credit exposure
disadvantage of VAR
2.can not show worse scenario
1.historial data
chosen confidence interval depends on the risk appetite of the organization that assumes credit risk
trading desk are often given a VAR limit, which represents risk tolerance of organization
how to measure credit exposure
1.MTM
definition: the replacement cost of the counter party
some features of MTM
1.zero sum game
a transaction is entered at prevailing market conditions, the MTM value of the deal is zero at inception
Amortization effect: fewer and fewer payment occur, MTM value would decline over time
impact MTM
3.prevailing conditions at the time the computation is performed
time left in the contract: longer time , larger exposure
the predetermined conditions of the contract , exercise price
problem of MTM
does not provide information about future
2.VAR
Chapter 6: Fundamental credit analysis
The agency relationship between shareholder and debtholder
why there is misalignment of shareholder and debtholder
shareholder are highly motivated to take risks since this has the potential for large gains
2.shareholders are in a first-loss position, so any new capital they inject into a company with precarious finances is prone to being lost
what is agency between those two
shareholder can be considered as the agent of debtholder. Shareholder can make decision affect corporation's profitability and risk profile, they affect the value of debt, and, thus impact creditors directly.
Analyze a company's credit strength from accouting
income statement( profit and loss statement)
cash-flow statement
balance sheet
Merton 's view on credit risk
definition: express owning equity stock in a company as equivalent to simultaneously owning a European call option and debtholder's position as selling a put option on the company's assets, with strike price being the value of the company's debt
factors impact default probability
time to maturity
the volatility of company operation
existing distance between asset to debt
chapter7: Alternative estimation of credit quality
calculate credit quality and default probability
traditional way
observe similar entities's credit quality
given rating by rating agencies
New way
KMV EDF
credit default swap
EDF
this model translate distance to default to default frequency probability
based on Black-scholes model for option pricing and idea of Merton on equity
second pillar uses Black-Scholes option pricing theory to find the market value of a firm's assets
first pillar is express equity as a call on the firm's assets
pros
has a forward-looking view
provides a default probability directly
is a bridge between the credit and equity markets
is upgraded everyday and therefore, reflect all information
cons:
the EDF relies on book value of debt
EDF is volatile since equity market is volatile
future can never be known with certainty
EDF only works for public trade firms
it is a black box
Credit default swap
disadvantage/ some factors influence CDS
credit risk of seller
liquidity risk of the CDS itself
overall supply and demand for protection in the marketplace
MTM risk of the CDS
definition
CDS prices reflect buyers and sellers views on the creditworthiness of an reference entity
is a insurance against credit risk, CDS is executed as a derivative transaction
higher the perceived credit risk, the more expensive the price
chapter8 : securitization
two types of collateral
static collateral
auto loans and mortgages
revolving colleteral
assets are short-term, credit card receivables
what is securitization
asset securitization refer to the creation of securities that used to fund asset purchases and borrowing or to transfer risk
securitization for risk transfer
investor can buy securities issued by SPV to transfer risk or profit through getting this risk
CLN
credit-linked notes
proceeds of which fund an escrow account to established to make payments to a protection buyer should a predetermined credit event occur
ILS
catastrophe bonds
insurance companies to protect against catastrophic events like earthquake or hurricanes
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