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Credit risk measurement and management of the loan portfolio - Coggle…
Credit risk measurement
and management
of the loan portfolio
Credit risk management
The purpose
achieve and appropriate balance between risk and
return
avoid concentration risk
take a group of loans off the statement of financial
position
management loans on a portfolio basic
Credit risk measurement
Altman's Z Score
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
Using stock prices
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:
estimate the current value and volatility of the firm’s assets
determine how far the firm is from default (its distance from default)
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
Portfolio management
Risk-adjusted return on capital
Risk adjusted return on capital =Income from the loan for one year/ Capital at risk
∆L = (-Dl)
(L)
(∆R/(1+Rl))
Altman'S Sharpe Index approach: 3 step
Step 1: Calculate return on portfolio
Step 2: Calculate variance of the portfolio
Step 3: Maximize the relationship which is the Sharpe
Index
CreditMetricsTM
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
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:
Loan pricing
Statement of Financial Position Costs
Capital Cost
Liquidity cost
Cost of Funds
Non credit Risk Costs
Interest Rate Risk
Pre-payment Risk
Origination Costs
Credit Costs
expected losses: Default Probability x (1 – Recovery Rate)
Unexpected Losses: Generally reflects volatility of Expected
Losses