Default Risk

7 Key excerpts on "Default Risk"

• 

  eBook - PDF

  The Validation of Risk Models

  A Handbook for Practitioners

  • S. Scandizzo(Author)
  • 2016(Publication Date)
  • Palgrave Macmillan

    (Publisher)

  Lastly the rating can be adjusted upward or downward for additional reasons like parental support, as a warning signal, as well as for any other factor not being considered by the model (with the appropriate justification provided). Today’s financial institutions’ approaches to a credit risk model are principally focussed on the estimation of the key parameters required under the Second Basel Accord: the probability of default (the probability that a given company will go into default within one year) the loss given default (the losses incurred on a defaulted loan as a percentage of the outstanding balance at time of default) and the exposure at default (the expected outstanding balance if the facility defaults, which is equal to the expected utilization plus a percentage of the unused commitments). Banks can calculate their regulatory capital charge for credit risk on the basis of these estimates. The risk measure to be used in credit risk models is therefore both accepted and standardized. However, related definitions are neither clear cut nor entirely homogeneous. A default event is defined by the BCBS as occurring when the obligor is either more than 90 days late in its payments or is unlikely to pay its obligation. While the first part of this definition may or may not imply losses (an obligor may well repay all its obligations in full even after a delay longer than 90 days), the second part implies a somewhat subjective judgment which may or may not turn out to be correct (Lehman Brothers was certainly likely to default, and indeed it did, but so was Merrill Lynch, who in the end did not). In structural option-theoretic models, a firm is in default if the value of its assets falls below that of its liabilities, while several scholars use actual bankruptcy, in the sense of Chapter 11 reorganization under U.S.

  Sign up to read

  Learn more about book
• 

  eBook - ePub

  2024 CFA Program Curriculum Level I Box Set

  • (Author)
  • 2023(Publication Date)
  • Wiley

    (Publisher)

  Market risk is the risk that arises from movements in interest rates, stock prices, exchange rates, and commodity prices. This categorization is not to say that these four main factors are the underlying drivers of market risks. Market risks typically arise from certain fundamental economic conditions or events in the economy or industry or developments in specific companies. These are the underlying risk drivers, which we will cover later.

  Market risks are among the most obvious and visible risks faced by most organizations and many individuals. The financial markets receive considerable attention in the media, and information on financial market activity is abundant. Institutional investors and many corporations devote considerable resources to processing this information with the objective of optimizing performance. Many individuals also devote considerable attention to market risk, and financial publications and television and radio shows are widely followed in the general population. The state of knowledge in risk management is probably greatest in the area of market risk.

  The second primary financial risk is credit risk. Credit risk is the risk of loss if one party fails to pay an amount owed on an obligation, such as a bond, loan, or derivative, to another party. In a loan, only one party owes money to the other. In some types of derivatives, only one party owes money to the other, and in other types of derivatives, either party can owe the other. This type of risk is also sometimes called Default Risk and sometimes counterparty risk. As with market risk, the root source of the risk can arise from fundamental conditions in the economy, industry, or weakness in the market for a company’s products. Ultimately, default is an asset-specific risk. Bond and derivatives investors must consider credit risk as one of their primary decision tools.12

  Sign up to read

  Learn more about book
• 

  eBook - PDF

  Value at Risk and Bank Capital Management

  Risk Adjusted Performances, Capital Management and Capital Allocation Decision Making

  • Francesco Saita(Author)
  • 2010(Publication Date)
  • Academic Press

    (Publisher)

  Intuitively, if two of its components (or even all three of them) were correlated, the expected loss would depend as well on those correlations. 2. Risk is defined by the Oxford Thesaurus as “uncertainty, unpredictability.” In this sense, expected losses are not part of risk, since they are predicted by the bank as the “normal” level of losses associated with a credit portfolio. 3. More precisely, the recovery rate (RR) is defi ned here as the ratio between the value of the credit-sensitive exposure after the default to the exposure at the time of default (EAD). 4. As described in Section 4.6, the Notice for Proposed Rulemaking issued by the U.S. Federal Banking Agen-cies in September 2006 defines loss given default as “an estimate of the economic loss that would be incurred on an exposure, relative to the exposure’s EAD, if the exposure were to default within one year during economic downturn conditions ,” while the generic LGD is labeled expected loss given default (ELGD). In this chapter, however, we follow the Basel II terminology, in which the generic term loss given default is not necessarily linked to a negative phase of the economic cycle (even if the estimate has to be conservative enough for regulatory purposes). Note that, generally speaking, the expected “exposure at default” could differ from the current exposure, depending on loan characteristics. For instance, when considering a 5000 USD irrevocable loan commitment with a drawn portion currently equal to 1000 USD, we should consider the risk that, at the time of default, the use could have increased to, say, 2000, 3000, or even 5000 USD. This is because, as default approaches, firms typically experience financial trouble and hence increase the drawn portion of the loan commitments available. Therefore, exposure at default could be different from (and typi-cally higher than) current exposure; this is currently referred to as exposure risk .

  Sign up to read

  Learn more about book
• 

  eBook - PDF

  Practical Risk Management

  An Executive Guide to Avoiding Surprises and Losses

  • Erik Banks, Richard Dunn(Authors)
  • 2004(Publication Date)
  • Wiley

    (Publisher)

  20 Practical Risk Management market value of the debt is likely to fall dramatically, but remain above default price levels. Losses sustained in these situations can be described either as credit or market risk losses. Trading credit risk is the risk of loss due to a counterparty defaulting on a bilateral obliga- tion; this risk usually appears in structured products, like derivatives or repurchase agreement financings (or “repos” – a repo is a short-term collateralized borrowing, where one firm agrees to sell securities to another firm and simultaneously agrees to repurchase them at a future time; the securities sold act as collateral, the cash proceeds from the sale act as a loan. A reverse repurchase agreement (“reverse repo”) is the same transaction seen from the perspective of the lender). These obligations do not always expose a firm to risk of loss – depending on whether a contract has been purchased or sold, and how much the contract is worth at the time of default. For example, if a bank sells a company an option, once the option has been paid for it does not have any credit risk since it is not looking to the company for performance – there is no scenario where the company can owe the bank money. In contrast, the company that has bought the option expects the bank to perform and so has credit risk to the bank. However, if the contract is close to expiring and out-of-the-money when the bank defaults, it will not lose any money. Contingent credit risk is the risk of loss due to counterparty default on a possible future extension of credit. Though many credit-sensitive transactions have credit exposure on trade date, some might not carry any risk until some future point – if at all. For instance, a client might draw down on a revolving credit facility or commercial paper program in the future – or might not! If it draws down, the bank faces additional credit risk, if it does not, then no incremental exposure arises.

  Sign up to read

  Learn more about book
• 

  eBook - PDF

  Risk Management and Simulation

  • Aparna Gupta(Author)
  • 2016(Publication Date)
  • CRC Press

    (Publisher)

  Institutions are also exposed to the risk that a counterparty, which may be another institution or a government, is downgraded by a rating agency. Credit risk is an issue when the position has a positive replacement value (i.e., is an asset), where either all the market value of the position is lost, or more commonly, part of the value of the asset is recovered after a credit event. This defines the terms recovery value or recovery rate , and the amount that is Defining Risk 11 expected to be lost is the loss given default amount. Credit risk is often called counterparty risk when the security in question is other than bonds and loans. Liquidity risk. Liquidity is having access to cash when needed. Liquidity risk is identified as either funding liquidity risk or asset liquidity risk. Funding liquidity risk refers to a firm’s ability to raise necessary cash to meet its immediate cash needs, such as, for rolling over its debt, or to meet the cash, margin or collateral requirements of counterparties. Asset liquidity risk is when an institution cannot convert the value of an asset to cash. This would arise if the institution is not able to execute a transaction at the prevailing market price because at the time there is no appetite for the deal on the other side of the market. Liquidity risk can result in substantial losses, but this risk is hard to quantify. It affects an institution’s ability to manage and hedge market risk, and capacity to fund shortfalls in funding by liquidating assets. Business risk. This is the classic risk of conducting business arising due to demand uncertainty, fluctuation in prices, cost of production, supplier costs, and availability. These are managed through core tasks of management, by choice of channels, products, suppliers, marketing, etc. It is important to con-nect business risk management within a formal enterprise risk management framework, by integrally combining market risk, credit risk with business risks.

  Sign up to read

  Learn more about book
• 

  eBook - PDF

  Fundamentals of Finance

  Investments, Corporate Finance, and Financial Institutions

  • Mustafa Akan, Arman Teksin Tevfik(Authors)
  • 2020(Publication Date)
  • De Gruyter

    (Publisher)

  – Diversification. Risky loans can be backed up through new capital injection or diversification through finding new loan markets. The quantitative method of credit risk analysis requires the use of financial data to predict the probability of default by the borrower. The methods, which are com-monly used, are discriminant analysis and logit and probit models . These methods are statistical techniques and involve methods similar to regression. The probability of defaults is calculated on the basis of some important predetermined variables such as age, marital status, residence, and qualification. Firm-specific credit risk refers to the likelihood that specific individual assets may deteriorate in quality, while systematic credit risk involves macroeconomic fac-tors that may increase the Default Risk of all firms in the economy. Thus, if a rating company lowers its rating on a certain stock and an investor is holding only this par-ticular stock, the company may face significant losses as a result of this downgrad-ing. However, portfolio theory in finance has shown that firm-specific credit risk can be diversified away if a portfolio of well-diversified stocks is held. Similarly, if an FI holds well-diversified assets, the FI will face only systematic credit risk that will be affected by the general condition of the economy. 5 The risks specific to any one cus-tomer will not be a significant portion of the FI ’ s overall credit risk. 16.4 Managing Interest-Rate Risk Financial institutions – banks, in particular – specialize in earning a higher rate of return on their assets relative to the interest paid on their liabilities. A simple exam-ple will suffice to explain that risk. Suppose a financial institution buys a long-term bond after valuing it by dis-counting the related cash inflows from the bond at a certain interest rate (discount rate). However, if the discount rate changes due to an external reason, the value of the bond will decline, causing a loss.

  Sign up to read

  Learn more about book
• 

  eBook - PDF

  Introduction to Credit Risk Modeling

  • Christian Bluhm, Ludger Overbeck, Christoph Wagner(Authors)
  • 2016(Publication Date)
  • Chapman and Hall/CRC

    (Publisher)

  Chapter 1 The Basics of Credit Risk Management Why is credit risk management an important issue in banking? To answer this question let us construct an example which is, although simplified, nevertheless not too unrealistic: Assume a major building company is asking its house bank for a loan in the size of 100 million Euro. Somewhere in the bank’s credit department a senior analyst has the difficult job of deciding if the loan will be given to the customer or if the credit request will be rejected. Let us further assume that the analyst knows that the bank’s chief credit officer has known the chief executive officer of the building company for many years, and to make things even worse, the credit analyst knows from recent default studies that the building industry is under hard pressure and that the bank-internal rating 1 of this particular building company is just on the way down to a low subinvestment grade (low credit quality). What should the analyst do? Well, the most natural answer would be that the analyst should reject the deal based on the information she or he has about the company and the current market situation. An alternative would be to grant the loan to the customer but to insure the loss potentially arising from the engagement by means of some credit risk management instrument (e.g., a so-called credit derivative ). Admittedly, we intentionally exaggerated in our description, but sit-uations like the one just constructed happen from time to time and it is never easy for a credit officer to make a decision under such difficult circumstances. A brief look at any typical banking portfolio will be suf-ficient to convince people that defaulting obligors belong to the daily business of banking the same way as credit applications or ATM ma-chines. Banks therefore started to think about ways of loan insurance 1 A rating is an indication of creditworthiness; see Section 1.1.1.1. 1

  Sign up to read

  Learn more about book