Credit risk is the risk of an economic loss from the failure of a couterparty to fulfill its contractual obligations.
its effect is measured by the cost of replacing cash flow if the other party defaults
it requires constructing the distribution of default probabilities, of loss given default (LGD), and of credit exposures
traditionally, it is viewed as **presettlement risk, which arises during the life of the obligation
Presettlement risk is the risk of loss due to the counterparty's failure to perform on an obligation during the life of the transaction
it includes the default on a loan or bond or failure to make required payment on a derivative transaction
it exists over long periods
Settlement risk is due to the exchange of cash flow and is of a much shorter-term nature
it arises as soon as an institution makes the required payment and exists until the offsetting payment is received
the risk is greatest when payments occur in different time zones, especially for foreign exchange transactions where notional are exchanged in different currencies
it can be caused by counterparty default, liquidity constraints, or operational problems
Status of a trade
Revocable: When the institution can still cancel the transaction without the consent of the counterparty
Irrevocable: After the payment has been sent and before payment from the other party is due
Uncertain: After the payment from the other party is due but before it is actually received
Settled: After the counterparty payment has been received
Failed: After it has been established that the counterparty has not made the payment
Settlement risk occurs during the period of irrevocable and uncertain status (one to three days)
Credit risk measurement systems attempt to quantify the risk of losses due to counterparty default
probability of default (PD)
credit exposure (CE)
loss given default (LGD) or recovery rate
The borrower has the option to default, so the payment pattern is exactly equivalent to a short position in an option CEt=max(Vt,0)
Measurement of Credit Risk
Measurement of Credit Risk
Notional amounts, adding up simple exposures
Risk-weighted amounts, adding up exposures with a rough adjustment for risk
Notional amounts combined with credit rating, adding up exposures adjusted for default probabilities
Internal portfolio credit models, integrating all dimensions of credit risk
Credit Risk versus Market Risk
Measuring Credit Risk
Credit Losses
Default mode: suppose all losses are due to the effect of defaults only.
The distribution of cresit losses (CLs) from a portfolio of N instruments issued by different obligators can be described as CL=i=1∑Nbi×CEi×(1−fi)
If b, CE and f are all independent, he expected credit loss is E[CL]=i=1∑NE[bi]×E[CEi]×E[LGDi]=i=1∑Npi×E[CEi]×E[LGDi]
If assuming CEi=$1 for all i=1,2,…,n, we have ECL=E[i=1∑nLGDi]=E[n]E[LGD]=npE[LGD]
The variance can be derived using the following formula V[CL]=E{V[CL∣n]}+V{E[CL∣n]}=E{nV[LGD]}+V{nE[LGD]}
So we have V[CL]==E[n]V[LGD]+v[n]{E[LGD]2}NpV[LGD]+Np(1−p){E[LGD]2}
When N=1, the standard deviation is SD[CL]=pV[LGD]+p(1−p){E[LGD]2}
Measuring Actuarial Default Risk
Credit Event
Credit Event
Definition of default by Standard & Pool's
Definition of credit event by International Swaps and Derivatives Association (ISDA)
Other events sometimes included are
Default Rates
Credit Ratings
A credit rating is an ''evaluation of creditworthiness'' issued by a credit rating agency (CRA).
The major U.S. bond rating agencies are
Moody's Investors Service
Standard and Pool's (S&P)
Fitch Ratings
Moody's definition of a credit rating
Ratings represent objective (or actuarial) probabilities of default
published default frequencies can be used to convert ratings to default probabilities
Ratings
investment grade
speculative grade, or below investment grade
Classes & modifiers (also called notches)
Accounting ratios & credit ratings
Multiple Discriminant Analysis (MDA)
MDA constructs a linear combination of accounting data that provides the best fit with the observed states of default and non-default for the sample firms
z−score is an example of MDA
z−score (Altman, 1968), variable used are:
X1: working capital over other assets,
X2: retained earnings over total assets,
X3: EBIT over total assets,
X4: market value of equity over total liabilities,
X5: net sales over total assets. Z=1.2X1+1.4X2+3.3X3+0.6X4+0.999X5
z−score
<1.8
1.8∼2.7
2.7∼3.0
>3.0
implications
very likely to default
good chance of default
on alert
unlikely to default
Historical Default Rates
The standard deviation of default probability (about 0.01%) for AA-rated credits is on the same of as the average (0.01%)
Estimation of default rates for low probability events can be very imprecise
Cumulative and Marginal Dafault Rates
Cumulative default rates measure the total frequency of default at any time between the starting date and year T, while marginal default rates measure default during year T
Notations
m[t+N∣R(t)]: the number of issuers rated R at the end of year t that default in year T=t+N
n[t+N∣]: the number of issuers rated R at the end of year t that have not default by the beginning of year T=t+N
Calculating rates
Marginal Default Rate during Year T : dN(R)=n[t+N∣R(t)]m[t+N∣R(t)]
Survival Rate: SN(R)=∏i=1N(1−di(R))
Marginal Default Rate from Start to Year T : kN(R)=SN−1(R)dN(R)
Average Default Rate: CN=1−∏i=1N(1−di)=1−(1−d)N
Average Default Rate for different compounding frequencies: CN=1−(1−da)N=1−(1−ds/2)2N→1−e−dcN
Transition Probabilities
Recovery Rates
The Bankruptcy Processes
Pecking order for a company's creditor:
Estimates of Recovery Rates
The recovery rate depends on the following factors:
The recovery rate for corporate debt.
The legal environment is also a main driver of recovery rates.
Trading prices of debt shortly after default can be used as an estimator of recovery rate, however, they are on average lower than the discounted recovery rates
clienteles for the two markets are different
risk premium in trading price
An opportunity: buying the defaulted debt and working through the recovery process should create value
distress securities funds
Measuring Default Risk from Market Prices
Corporate Bond Prices
Spreads and Default Risk: Single Period
Suppose a bond has a single payment $100 in one period, the market-determined yield y∗ can be derived from its price P∗ P∗=(1+y∗)$100
We apply risk-neutral pricing:
We compound interest rates and default rates over each period.Let πa be the average annual default rate. P∗=(1+y∗)T$100=[(1+y)T$100]×(1−πa)T+[(1+y)Tf×$100]×[1−(1−πa)T] ⟹(1+y)T=(1+y∗)T{(1−πa)T+f[1−(1−πa)T]}
If we use the cumulative default probability (1+y∗)T1=[(1+y)T1]×(1−π)+[(1+y)Tf×1]×[1−(1−π)]
A very rough approximation: ⟹(1+y∗)T1=[(1+y)T1]×[1−π(1−f)]⟹y∗≈y+(π/T)(1−f)
Risk Premium
In the previous analysis we assume risk neutrality. As a result, π is a risk neutral measure, which is not necessarily equal to the objective, physical probability of default.
Assuming π′ and y′ be the physical probability of default and the discount rate. We have the following
The risk premium (rp) must be tied to some meaure of bond riskiness as well as investor risk aversion. In addition, this premium may incorporate a **liquidity premium and tax effects.
Cross-Section of Yield Spreads
The transition from Treasuries to AAA credit most likely reflects other factors, such as liquidity and tax effects, rather than actuarial credit risk
We can use information in corporate bond yield to make inferences about credit risk
Movements in corporate bond prices tend to \textit{lead changes in credit ratings
Time Variation in Credit Spreads
Part of default risk can be attributed to common credit risk factors such as
General Economic conditions
growth
slow down
Volatility
investors require more risk premium in a more volatile environment
liquidity may dry up
The effect of volatility through an option channel
a callable bond = bond + (short) a call
the value of call increases in a more volatile environment
Equity Prices
The Merton Model
The Merton (1974) model views equity as akin to a call option on the assets of the firm, with an exercise price given by the face value of debt
Consider a firm with total value V that has one bond due in one period with face value K
equity can be viewed as a call option on the firm value with strike price equal to the face value of debt ST=max(VT−K,0)
the current stock price embodies a forecast of default probability in the same way that an option embodies a forecast of being exercised
corporate debt can be viewed as risk-free debt minus a put option on the firm value BT=VT−ST=min(VT,K)=K−max(K−VT,0)
Pricing Equity and Debt
Firm value follows the geometric Brownian motion dV=μVdt+σvdz
The value of firm can be decompose in to the value of equity (S) and the value of debt (B). The corporate bond price is obtained as B=F(V,t),F(V,T)=min(V,BF),BF=K
The equity value is S=f(V,t),f(V,T)=max(V−BF,0)
Stock Valuation S=Call=VN(d1)−Ke−rτN(d2)
where d1=στln(V/Ke−rτ)+2στ,d2=d1−στ
Firm Volatility σV=(1/Δ)σS(S/V)
Bond Valuation B=Risk-free bond−Put⟹B/Ke−rτ=N(d2)+(V/Ke−rτ)N(−d2)
某风险分析师尝试估计一个BB级债券的收益率。如果无风险利率为每年3.5%,BB级债券的违约概率为7%,违约损失率(Loss given default)为70%。请估计该债券的到期收益率。
Credit Exposures
Credit Exposore by Instrument
Credit Exposore by Instrument
Credit exposure: CEt=max(Vt,0)
current exposure is the value of the asset at the current time Vt if possitive
potential exposure represents the exposure on some future date, or set of dates
Loans or Bonds
loans or bonds are balance sheet assets whose current and potential exposure basically is notional, or amount lent or invested
the exposure is also notional for receivables and trade credits, as the potential loss is the amount due
Garantees
guarantees are off-balance-sheet contracts whereby the bank has underwritten, or agrees to assume, the obligations of a third party.
the exposure is the notional amount
it is irrevocable
Commitments
Commitments are off-balance-sheet contracts whereby the bank commits to a future transaction that may result in creating a credit exposure at a \textit{future date
**irrevocable commitments vs. **revocable commitments
Swaps or Forwards
Swaps or forwards contracts are off-balance-sheet items that can be viewed as irrevocable commitments to purchase or sell some asset on prearranged terms
the current and potential exposure will vary from zero to a large amount depending on movements in the driving risk factors
similar arrangement are **sale-repurchase (repos)
Long Options
Options are off-balance-sheet items that may create many credit exposure
the current and potential exposure will vary from zero to a large amount depending on movements in the driving risk factors
there is no possibility for options to have negative values
Short Options
the current and potential exposure for short options is zero because the bank writting the option can incur only a negative cash flow, assuming the option premium has been fully paid
Distribution of Credit Exposure
Expected & Worse Exposure
The expected credit exposure (ECE) is the expected value of the asset replacement value x, if positive, on a target date: ECE=∫−∞∞x+f(x)dx
The worse credit exposure (WCE) is the largest (worst) credit exposure at some level of confidence. It is implicitly defined as the value that is not exceeded at the given confidence level p: 1−p=∫WCE∞f(x)dx
To model the potential credit exposure, we need to
model the distribution of risk factors
evaluate the instrument given these risk factors
the process is identical to a market value at risk computation
the aggregation takes place at the counterparty level if contracts are netted
Time Profile
The average expected credit exposure (AECE) is the average of the expected credit exposure over time, from now to maturity T:
AECE=T1∫t=0TECEtdt
The average worst credit exposure (AWCE) is defined similarly:
AWCE=T1∫t=0TWCEtdt
Exposure Modifiers
Exposure Modifiers
Marking-to-Market (MTM)
involves settling the variation in the contract value on a regular basis
it is called two-way marking to market if the treatment is symmetrical across the two counterparties
if one party settles losses only, it is called one-way marking to market
Daily MTM reduces the current credit exposure to zero, however there is still potential exposure because the value of the contract would change before the next settlement. Potential exposure arises from:
the time interval between MTM periods
the time required for liquidating the contract when the counterparty defaults
MTM introduces other types of risks
operational risk, which is due to the need to keep track of contract values and to make or receive payments daily
liquidity risk, because the institution now needs to keep enough cash to absorb variations in contract value
Margins
Margins represent the cash or securities that must be advanced in order to open a position
the purpose of these funds is to provide a buffer against potential exposure
initial margin vs. maintenance margin
Margins are set in relation to price volatility and to the type of position, speculation or hedging
margins increase for more volatile contracts
margins are typically lower for hedgers
Collateral
OTC markets may allow posting securities as collateral instead of cash
the amount of collateral will exceed the funds owed by an amount known as haircut, which reflects both default risk and market risk.
collateral is typically managed within the International Swap and Derivatives Association (ISDA) credit support annex (CSA)
Exposure Limits
Credit exposure can also be managed by setting position limits on the exposure to a counterparty
To enforce limits, information on transactions must be centralized in middle-office systems
These limits can also be set at the instrument level
Recouponing
Recouponing refers to a clause in the contract requiring the contract to be marked to market at some fixed dates. It involves
exchanging cash to bring the MTM value to zero
resetting the coupon or the exchange rate to prevailing market value
Netting Arrangements
It reduces the exposure to the net value for all the contracts covered by the netting agreement
Nettings can be classified into three types:
payment netting involves the daily offsetting of several claims in the same currency
novation netting involves the cancellation of several contracts between the two parties, resulting in a replacement contract with new, net payments
close-out netting involves the cancellation of all transactions under the master agreement in the event of bankruptcy or any other specified default event
Other Modifiers
third-party guarantees
purchasing credit derivatives
Credit Risk Modifiers
Credit Risk Modifiers
Credit triggers specify that if either counterparty's credit rating falls below a specified level, the other party has the right to have the swap cash settled
these are not exposure modifiers, but rather attempt to reduce the probability of default on that contract
these triggers are useful when the credit rating of a firm deteriorates slowly, because few firms jump directly from investment grade into bankruptcy
Time puts, or mutual termination options, permit either counterparty to terminate the transaction unconditionally on one or more dates in the contract.
the feature decreases both the default risk and exposure
it allows one counterparty to terminate the contract if the exposure is large and the other party's rating starts to slip
Triggers and put, which are types of contingent requirements, can cause serious trouble
Credit Derivatives and Structured Products
Introduction
Introduction
Credit derivatives provide an efficient mechanism to echange credit risk
credis risk can not be perfectly diversified for banks
banks can keep the loans on their books and to buy protection with credit derivatives
Credit derivatives are over-the-counter contracts that allow credit risk to be exchanged across counterparties. They can be classified in terms of the following
The underlying credit, which can be a single entity (single name) or a group of entities (multiname)
The exercise conditions, which can be a credit event (such as default or rating downgrade, or an increase in credit spreads)
The payoff function, which can be a fixed amount or a variable amount with a linear or nonlinear payoff
Credit Default Swaps
Definition of CDS
In a credit default swap contract, a protection buyer (say A) pays a premium to the protection seller (say B), in exchange for payment if a credit evet occurs
the premium payment can be a lump sum or periodic
the contigent payment is triggered by a credit event (CE) on the underlying credit, say a bond issued by company Y
A CDS is a option instead of a swap
the main difference from a regular option: the cost of a option is paid in installments instead of up front
if the cost is paid up front, the contract is called a default put option
the annual payment is referred as the CDS spread
An example of CDS
Most CDS contracts are quoted in terms of an annual spread, with the payment made on quarterly basis
Default swaps are embedded in many financial products, for example:
Settlement
The payment (Q) on default reflects the losses to the holders of the reference asset when the credit event occur. It takes a number of forms:
cash settlement, or a payment equal to the strike minusthe prevailing market value of the underlying bonds
physical settlement of the defaulted obligation in exchange for a fixed payment
a lump sum, or a fixed amount based on some pre-agreed recovery rate. (if the CE occurs, the recovery rate is set at 40%, leading to a payment of 60% of the notional)
The payoff of a CDS is Payment=Notional×Q×I(CE)
binary credit default swap: Q=1
with physical settlement, the contract defines a list of bond, which can trade at different prices but must be exchanged for their face value, that can be delivered (delivery option)
cash settlement can be conducted through an auction, which defines the recovery rate
Pricing
CDS contracts can be priced by considering the present value of the cash flows on each side of the contract.
The value V and the fair spread s of the CDS contract should satisfy the following:
The default probabilities used to price the CDS contracts must be risk-neutraal probabilities, not real-world probabilities.
Counterparty Risk
A CDS does not eliminate credit risk entirely.
the protection buyer decreases exposure to the reference credit Y but assume new credit exposure to the CDS seller
correlation between the default risk of the underlying credit and of the couterparty is important
A CDS is unfunded
unfunded: each party is resposible for making payments without recourse to other assets
ufunded: the protection seller makes a payment that could be used to settle any potential redit event
Other Contracts
CDS Variants
The first-of-basket-to-default swap gives the protection buyer the right to deliver one and only one defaulted security out of a basket of selected securities
the contract will be more expensive than a single credit swap, all else kept equal
the price of protection also depends on the correlation between credit events
With an Nth-to-default swap, payment is triggered after N defaults in the underlying portfolio, but not before
CDS indices are widely used to track the performance of this market
the iTraxx indices cover the most liquid names in European and Asian credit markets
the North American and emerging markets are covered by the CDX indices
Total Return Swaps
A total return swap (TRS) is a contract where one party, called the protection buyer, makes a series of payments linked to the total return on a reference asset. In exchange, the protection seller makes a series of payments tied to a reference rate, such as the yield on an equivalent Treasury issue (or LIBOR ) plus a spread.
TRS provides protection against credit risk in a mark-to-market (MTM) framework
For the protection buyer, the TRS removes all the economic risk of the underlying asset without selling it
Unlike a CDS, the TRS involves both creditrisk and market risk, the latter reflecting pure interest rate risk
Credit Spread Forwards and Option
In a credit spread forward contract, the buyer receives the difference between the credit spread at maturity and an agreed-upon spread, if positive. Conversely, a payment is made if the difference is negative. The payment is, Payment=(S−F)×MD×Notional
Or, equivalently Payment=[P(y+F,τ)−P(y+S,τ)]×Notional
In a credit spread option contract, the buyer pays a premium in exchange for the right to put any increase in the spread to the option seller at a predefined maturity: Payment=(S−K)+×MD×Notional
Structured Products
Credit-Linked Notes
Credit-linked notes (CLNs) are structured securities that combine a credit derivative with a regular bond
the buyer of protection transfers credit risk to an investor via an intermediary bond-issuing entity
the entity can be the buyer itself or a special-purpose vehicle (SPV)
this structure may carry a higher yield if the CDS spread is greater than the bond yield spread
this structure may also be attractive to investors who are precluded from investing directly in derivatives
Collateralized Debt Obligations
The waterfall structure of CDO
In this example, 80% of the capital structure is apportioned to tranche A, which has the highest credit rating of Aaa, using Moody’s rating, or AAA. It pays LIBOR + 45bp, for example. Other tranches have lower priorities and ratings. These intermediate, mezzanine, tranches are typically rated A, Baa, Ba, or B (A, BBB, BB, B, using S&P's ratings). For instance, tranche C would absorb losses from 3% to 10%. These numbers are called, respectively, the attachment point and the detachment point.
Managing Credit Risk
Measuring the Distribution of Credit Losses
Measuring the Distribution of Credit Losses
Default mode (DM): considering only losses due to defaults instead of changges in market values
For a portfolio of N conterparties, the credit loss (CL) is CL=i=1∑Nbi×CEi×LGDi
The net replacement value (NRV) NRV=i=1∑NCEi
A typical distribution of credit profits & losses (P&L)
The distribution of P&L is \textit{highly skewed to the left
similar to a short position in an option
Merton model: A Risky bond=A risk-free bond+short an option
Major features
The Expected credit loss (ECL) represents the average credit loss. The pricing of the portfolio should be such that it covers the expected loss
The Unexpected credit loss (UCL) represents the loss that will not be exceeded at some level of confidence, typically 99.9%. Taking the deviation from the expected loss gives the unexpected credit loss. The institution should have enough equity capital to cover the unexpected loss.
The effect of correlations
Correlations across default event bi
Correlations across default event and exposure
wrong-way trades: exposure is positively correlated with the probability of default
right-way trades occurs when the transaction is a hedge for the counterparty
The present value of expected credit losses (PVECL): PVECL=t∑E[CLt]×PVt=t∑[kt×ECEt×(1−f)]×PVt
It can be simplified by adopting the average default probability and average exposure over the life of the asset: PVECLA=Ave[kt]×Ave[ECEt]×(1−f)×[t∑PVt]
An even simpler approach, when ECE is constant, considers the final maturity T only, using the cumulative default rate cT and discount factor PVT: PVECLF=cT×ECE×(1−f)×PVT
Measuring Credit VaR
Measuring Credit VaR
Credit VaR over a Target Horizon
At a given confidence level c, the worst credit loss (WCL) is defined such that 1−c=∫WCL∞f(x)dx
Credit VaR is defined as the unexpected credit loss at some confidence level, which is measured as the deviation from ECL: Credit VaR=UCL=WCL−ECL
It should be viewed as the economic capital to be held as a buffer against unexpected losses
Using Credit VaR to Manage the Portfolio
rationales on trades: profitability vs. credit risk (credit VaR)
the marginal contribution to risk can be used to analyze the incremental effect of a proposed trade on the total portfolio risk
the marginal analysis can also help to establish the renumeration of capital required to support the position
Portfolio Credit Risk Models
Approaches to Portfolio Credit Risk Models
Model Type
Top-down models group credit risks using single statistics. They aggregate many sources if risk viewed as homogeneous into an overall portfolio risk, without going into the details of individual transactions. It is appropriate for retail portfolios with large numbers of credits, but less so for corporate or sovereign loans.
Bottom-up models account for futures of each instrument. It is most similar to the structural decomposition of positions that characterizes market VaR systems. It is appropriate for corporate and capital market portfolios. It is also most useful for taking corrective action, because the risk structure can be reverse-engineered to modify the risk profile
Risk Definitions
Default-mode models consider only outright default as a credit event
Mark-to-market (MTM) models consider changes in market values and ratings changes, including defaults
Models of Default Probability
Conditional models incorporate changing macroeconomic factors into teh default probability through a functional relationship
Unconditional models have fixed default probabilities and tend to focus on borrower-or factor-specific information
Models of Default Correlations
Structural Models explain correlations by the joint movements of assets
Reduced-form models explain correlations by assuming a particular functional relationship between the default probability and background factors