CREDIT RISK Ryan HanEol Jang Yonsei GSIS Int’l Trade and Finance

Contents  Definition of Risk Mgt  Types of Risk – identifying risk  Credit Risk  Evaluating Credit Risk  Managing Credit Risk

DEFINITION OF RISK MGT

Definition of Risk Mgt  Risk Mgt is a continual process of  Identifying and measuring specific risk exposure  Setting specific risk tolerance level  Reporting risk exposures to stakeholders  Monitoring the process and taking any necessary corrective actions

TYPES OF RISK

Types of Risk  Financial Risk  Market Risk I/R, exchange rates, equity prices, commodity prices  Liquidity Risk  Credit Risk  Sovereign Riskfin + non-fin

Types of Risk (cont’d)  Non-financial risk  Settlement risk  Operations risk  Model risk  Regulatory risk  Other risk Political risk Tax risk Accounting risk Legal risk

EVALUATING CREDIT RISK

Evaluating Credit Risk  What is Credit risk ?  Risk of loss caused by a counterparty or debtor’s failure to make a promised payment  Possibility of default by the counterparty to a financial transaction

Evaluating Credit Risk  Monetary exposure to credit risk = probability of default event X amount of money lost if default event occurs  Credit Exposure = loss given default  Credit exposure > 0  Have a claim  Become a creditor  Two time dimensions of Credit Risk  Current credit risk → currently due payment  Potential credit risk → payment due in the future

Evaluating Credit Risk  VaR  Max loss the company can experience At a given confidence level Over a specific period Under normal market  Ex) I am 96% confident the loss will be no greater than $1000 over the next month.  Credit VaR (=Credit at Risk = Default VaR)  Much the same but different from market VaR → focus on upper tail of return  NOT useful !

Evaluating Credit Risk – Bond  Unilateral  Cross-default-provision

Evaluating Credit Risk - Derivatives  Bilateral  Forward  There is no initial exchange of cash in fwd contract.  Each side assumes potential credit risk until the settlement date.  At the settlement date, one or both parties to fwd contracts will have to pay the other.  Value of the fwd contract is the PV of any net payoff.  Swap → series of fwd  Credit risk is potential until each settlement date.  Likewise, value of swap is PV of future settlement pmt.  Option  Unlike fwd and swap contracts, the credit risk is only borne by the long.  ∵ option is either out-of-money and no pmt is due, or in-money and short owes a pmt to long.

MANAGING CREDIT RISK

Managing Credit Risk  Non-VaR measures to control credit risk  limiting exposure  marking to mkt  collateral  pmt netting  imposing min credit standards on a debtor  Risk can be transferred to somebody else through credit derivatives such as  CDS  Credit Forward  Credit spread option  Total return swap

Nine Principles of effective Risk Mgt  There is no return without risk.  Be transparent.  Seek experience.  Know what you don’t know.  Communicate.  Diversify.  Show discipline.  Use common sense.  Return is only half the equation.

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