Credit risk measurement
and management
of the loan portfolio

  1. Credit risk management

The purpose

Credit risk measurement

achieve and appropriate balance between risk and
return

avoid concentration risk

take a group of loans off the statement of financial
position

Altman's Z Score

Using stock prices

Formular: Z = 1.2 X1 + 1.4 X2 + 3.3 X3 + 0.6 X4 + 1.0 X5

Credit decision relies on output from equation at
varying cutoff levels

To overcome the problem of using historical data, KMV Moody’s extended Merton’s option pricing model for risky debt

Process: There are three steps:

  1. estimate the current value and volatility of the firm’s assets
  2. determine how far the firm is from default (its distance from default)
  3. scale the distance to default to a probability.

Formula

Distance to default= (Mkt Value of Assets)(Asset Volatility)/(Mkt Value of Assets)-(Default Point) Distance

Expected default probability = Number of default firms/
All firms of sample

management loans on a portfolio basic

  1. Portfolio management

Risk-adjusted return on capital

Altman'S Sharpe Index approach: 3 step

CreditMetricsTM

Risk adjusted return on capital =Income from the loan for one year/ Capital at risk

∆L = (-Dl)(L)(∆R/(1+Rl))

Step 1: Calculate return on portfolio

Step 2: Calculate variance of the portfolio

Step 3: Maximize the relationship which is the Sharpe
Index

Incorporates changing credit risk over time by addressing migration probabilities, eg, AAA to AA, A to BB etc

Factor consideration

Year-end rating

Probability of rating state

New bonds value plus coupon

Probability-weighted value

Probability-weighted difference

Process

Step 1: Define the portfolio as individual assets

Step 2: For each asset, define cashflows and calculate PV for each state using zero-curve

Step 3: Using transition matrix, calculate probability-weighted PV and standard deviation

Step 4: Calculate portfolio risk by executing above steps for the joint probabilities for a loan in the portfolio to derive portfolio’s standard deviation

  1. Managing the portfolio

Securitisation

for packaging cashflows from loan assets
and selling them as securities

Type

Pass-Through Structures: Loan assets sold completely from statement of financial position through a Special Purpose Vehicle (SPV)

Pay-Through Structures: similar to Pay-Through structure but assets not sold, but only managed by SPV

Credit Derivatives

Credit Default Swaps:

Total Return Swaps:

Credit Options:

  1. Loan pricing

Statement of Financial Position Costs

Non credit Risk Costs

Credit Costs

Capital Cost

Liquidity cost

Cost of Funds

Interest Rate Risk

Pre-payment Risk

Origination Costs

expected losses: Default Probability x (1 – Recovery Rate)

Unexpected Losses: Generally reflects volatility of Expected
Losses