1. http://pluto.huji.ac.il/~mswiener/zvi.html 972-2-588-3049 FRM Zvi Wiener Following P. Jorion, Financial Risk Manager Handbook Financial Risk Management

2. http://pluto.huji.ac.il/~mswiener/zvi.html 972-2-588-3049 FRM Chapter 18 Introduction to Credit Risk Following P. Jorion 2001 Financial Risk Manager Handbook

3. Ch. 18, IntroCreditRiskZvi Wiener slide 3 Credit Risk Risk of an economic loss from the failure of a counterparty to fulfill its contract obligations. This type of risk can take various forms: failure to pay, settlement risk, covenants, credit derivatives, etc.

4. Ch. 18, IntroCreditRiskZvi Wiener slide 4 Settlement Risk Herstatt Bank failure 1974 March 1996, BIS report on settlement risk in FX market (>$1T/day), see www.bis.org/publ/cpss17.pdf Committee on Payment and Settlement Systems CLS, Target, netting, systemic risk. Real time gross settlement = RTGS Continuous linked settlement = CLS bank (1998)

5. Ch. 18, IntroCreditRiskZvi Wiener slide 5 Status of Trade Revocable – can be canceled Irrevocable - after the payment was sent but before the counter payment is due Uncertain – after the payment from counterparty is due but before it is received Settled – after the counterparty payment has been received. Failed – after it has been established that the counterparty has not made the payment.

6. Ch. 18, IntroCreditRiskZvi Wiener slide 6 Drivers of Credit Risk Default Credit exposure (EAD = exposure at default) Loss given default (LGD), fractional recovery

7. Ch. 18, IntroCreditRiskZvi Wiener slide 7 RM tools Notional amount Risk-weighted amounts External/internal credit ratings Internal portfolio credit models

8. Ch. 18, IntroCreditRiskZvi Wiener slide 8 Credit Losses b i is 1 if default occurs, 0 otherwise CE = credit exposure at the time of default f = recovery rate, (1-f) = LGD

9. Ch. 18, IntroCreditRiskZvi Wiener slide 9 Joint Events

10. Ch. 18, IntroCreditRiskZvi Wiener slide 10 Example

11. Ch. 18, IntroCreditRiskZvi Wiener slide 11 FRM-00, Question 46 An investor holds a portfolio of $50M. It consists of A-rated bonds ($20M) and BBB-rated bonds ($30M).Assume that the one-year probabilities of default are 2% and 4% respectively and are independent. The recovery rate for A-bond is 60% and recovery rate for BBB-bond is 40%. What is the one- year expected credit loss of this portfolio? A. $672,000 B. $742,000 C. $880,000 D. $923,000

12. Ch. 18, IntroCreditRiskZvi Wiener slide 12 FRM-00, Question 46 An investor holds a portfolio of $50M. It consists of A-rated bonds ($20M) and BBB-rated bonds ($30M).Assume that the one-year probabilities of default are 2% and 4% respectively and are independent. The recovery rate for A-bond is 60% and recovery rate for BBB-bond is 40%. What is the one- year expected credit loss of this portfolio? A. $672,000 B. $742,000 C. $880,000 = $20  0.02(1-0.6)+$30  0.04(1-0.4) D. $923,000

13. Ch. 18, IntroCreditRiskZvi Wiener slide 13 FRM-98, Question 42 A German Bank lends 100M DEM to a Russian bank for one year and receives 120M DEM worth of Russian government securities as collateral. Assuming that the 1-year 99% VaR on the Russian government securities is 20M DEM and the Russian bank’s 1-year probability of default is 5%, what is the German bank’s probability of losing money on thios trade over the next year? A. Less than 0.05% B. Approximately 0.05% C. Between 0.05% and 5% D. Greater than 5%

14. Ch. 18, IntroCreditRiskZvi Wiener slide 14 FRM-98, Question 42 A German Bank lends 100M DEM to a Russian bank for one year and receives 120M DEM worth of Russian government securities as collateral. Assuming that the 1-year 99% VaR on the Russian government securities is 20M DEM and the Russian bank’s 1-year probability of default is 5%, what is the German bank’s probability of losing money on this trade over the next year? A. Less than 0.05% B. Approximately 0.05% C. Between 0.05% and 5%, it is exactly 5% D. Greater than 5%

15. Ch. 18, IntroCreditRiskZvi Wiener slide 15 Credit Risk Diversification Single loan of $100M, with probability of default 1% and 0 recovery. The expected loss and st. dev are: EL = 1%  $100M = $1M,SD = $10M Consider 10 loans, each for $10M. The total notional is $100M. Assume that defaults are independent with probability 1% and 0 recovery: EL = 10  1%  10 = $1M,SD = $3M

16. Ch. 18, IntroCreditRiskZvi Wiener slide 16 More Examples