FRM Zvi Wiener Following P. Jorion, Financial Risk Manager Handbook Financial Risk Management

FRM Chapter 18 Introduction to Credit Risk Following P. Jorion 2001 Financial Risk Manager Handbook

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.

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 Committee on Payment and Settlement Systems CLS, Target, netting, systemic risk. Real time gross settlement = RTGS Continuous linked settlement = CLS bank (1998)

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.

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

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

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

Ch. 18, IntroCreditRiskZvi Wiener slide 9 Joint Events

Ch. 18, IntroCreditRiskZvi Wiener slide 10 Example

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

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

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%

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%

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

Ch. 18, IntroCreditRiskZvi Wiener slide 16 More Examples