Credit risk Study Guide

📖 Core Concepts Credit Risk – Chance a borrower fails to repay principal or interest, causing lost cash flows and higher collection costs. Loss‑Given‑Default (LGD) – % of exposure lost when default occurs. Probability‑of‑Default (PD) – Likelihood a borrower will default over a given horizon. Exposure‑at‑Default (EAD) – Amount owed at the moment of default. Expected Loss (EL) – $$\text{EL}= \text{PD}\times \text{LGD}\times \text{EAD}$$ (core risk‑pricing formula). Risk‑Based Pricing – Higher interest rates (credit spreads) are charged to borrowers with higher EL. Concentration Risk – Large exposure to a single borrower, industry, or country that can threaten a bank’s stability. Sovereign (Country) Risk – Risk of a government freezing foreign‑currency payments or defaulting on its obligations. Counterparty Credit Risk (CCR) – Risk that a contract‑counterparty fails to fulfill payment obligations (settlement risk). Credit Valuation Adjustment (CVA) – Adjustment to a derivative’s price to reflect CCR; Debit Valuation Adjustment (DVA) reflects the institution’s own default risk. Potential Future Exposure (PFE) – Forecasted maximum exposure over a future horizon, used in CCR calculations. Value‑at‑Risk (VaR) – Statistical estimate of the maximum loss over a set period at a chosen confidence level. --- 📌 Must Remember EL Formula: $EL = PD \times LGD \times EAD$. Higher Credit Risk → Higher Yield Spread (market pricing). SA‑CCR is the regulatory method to compute capital required for CCR. Credit Default Swap (CDS) spreads are market‑based measures of default risk. Risk‑Based Pricing Inputs: loan‑to‑value (LTV), credit rating, loan purpose. Loan Covenant Triggers: breach of debt‑to‑equity or interest‑coverage ratios can force immediate repayment. Diversification Mitigates Concentration Risk – spread exposures across borrowers/industries/countries. CVA ≈ PD × LGD × Expected Positive Exposure (simplified). --- 🔄 Key Processes Credit Risk Assessment Workflow Gather quantitative data (leverage, liquidity ratios). Collect qualitative data (management quality, industry outlook). Assign rating/score → set PD and LGD. Compute EL → decide on interest rate (risk‑based pricing). SA‑CCR Calculation (simplified) Determine Replacement Cost (RC) of derivatives. Compute Potential Future Exposure (PFE) using prescribed multiplier and supervisory factors. Apply Correlation Adjustment for netting sets. Capital requirement = $0.8 \times (\text{RC} + \text{PFE})$ (regulatory factor). Credit Derivative Hedging (CDS) Buyer pays periodic premium (CDS spread). Upon reference entity default, seller pays LGD × Notional to buyer. Loan Covenant Monitoring Periodic reporting → calculate covenant ratios. If breach → lender may declare event of default and demand repayment. --- 🔍 Key Comparisons Credit Default Risk vs. Counterparty Credit Risk Default Risk: borrower fails to meet loan obligations. CCR: counter‑party fails to settle a contract (e.g., derivative). Concentration Risk vs. Diversification Concentration: large exposure to single name/industry/country. Diversification: spreading exposures to lower unsystematic risk. Credit Insurance vs. Credit Derivatives Insurance: pays loss directly when borrower defaults. Derivatives (CDS): transfer risk to insurer; payoff tied to default event, not actual loss. CVA vs. DVA CVA: cost to the bank for the counter‑party’s possible default. DVA: benefit to the bank from its own potential default (reduces liability value). --- ⚠️ Common Misunderstandings “Higher LGD always means higher loss.” – LGD matters only when default occurs; PD drives frequency. “Sovereign risk only matters for government bonds.” – It also affects corporate borrowers operating in that country. “All credit spreads reflect pure default risk.” – Spreads also embed liquidity, tax, and market sentiment components. “CVA is a one‑time charge.” – CVA must be re‑estimated as PD, LGD, and exposure evolve. “Collateral eliminates CCR.” – Collateral reduces exposure but remains subject to haircuts, valuation timing, and correlation effects. --- 🧠 Mental Models / Intuition EL as Expected Damage – Think of PD as the chance of an accident, LGD as the severity of damage, and EAD as the value at stake. Multiply to get the average loss the bank should expect. Risk‑Based Pricing = Insurance Premium – The bank charges a “premium” (higher spread) proportional to the EL, just like an insurer charges higher premiums for higher‑risk policyholders. Concentration Risk = “All Eggs in One Basket” – The larger the basket, the more catastrophic the fall if it breaks. CVA ≈ “Credit Insurance Cost” – When you buy a CDS on a counter‑party, you are paying a premium equivalent to the CVA of that exposure. --- 🚩 Exceptions & Edge Cases Zero‑Coupon Bonds – EAD may be higher than face value at default due to accrued interest. Negative Yield Spreads – In rare market stress, high‑quality borrowers can trade at spreads below risk‑free rates (flight‑to‑quality). Collateral Haircuts – In volatile markets, haircuts increase, raising effective exposure despite posted collateral. Sovereign Guarantees – Even a sovereign‑backed loan can default if the guarantor’s own credit deteriorates (cross‑default risk). --- 📍 When to Use Which Use Credit Scoring / Scorecards – For high‑volume unsecured consumer loans and mortgages. Use Market‑Based Indicators (Yield/CDS Spreads) – When evaluating large corporates with liquid bonds or CDS contracts. Apply SA‑CCR – For any derivative portfolio subject to regulatory capital calculation. Choose Credit Insurance vs. CDS – Use insurance for direct loan loss protection; use CDS for synthetic exposure or when insurance is unavailable/expensive. Deploy Loan Covenants – When the borrower’s cash‑flow volatility is high or the loan is large relative to equity. --- 👀 Patterns to Recognize High PD + High LGD = High EL → High Spread – Spot this combination in credit proposals. Rising CDS Spread + Widening Bond Yield Spread = Deteriorating Credit Quality – Common in market‑driven assessments. Concentration of Exposures in One Industry + Economic Downturn → Elevated Portfolio Risk – Look for clustering in loan books. Positive Correlation Between Counterparty Default and Market Stress → Spike in CCR – Typical in crisis periods. --- 🗂️ Exam Traps Confusing LGD with PD – Remember LGD is severity (percentage loss), PD is likelihood. Assuming a higher coupon always means lower risk – Coupon reflects price, not credit quality; look at spreads. Treating CVA as a one‑off expense – It must be updated; exam may ask for periodic re‑valuation. Over‑relying on a single rating agency – Exams may test the need for multiple sources (ratings, market spreads, internal models). Ignoring collateral haircuts – A question that lists collateral value without a haircut is a trap; the effective exposure is higher. ---