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<title>Credit Risk Measurement and Management | Chapter 7 | Credit and Counterparty Risk</title>
<meta name="description" content="Financial Risk Manager Part 2 Study Materials">
<meta name="author" content="MacLane Wilkison">
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<section>
<h1>Chapter 7</h1>
<h3>Credit and Counterparty Risk</h3>
<p>
<small>Created for <a href="http://alchemistsacademy.com">Alchemists Academy</a> by <a href="http://alchemistsacademy.com/about">MacLane Wilkison</a></small>
</p>
</section>
<section>
<h2>Credit Risk</h2>
<p><em>Definition: The risk of economic loss from default or changes in ratings or other credit events</em></p>
</section>
<section>
<h2>Basic Principles</h2>
<ul>
<li>A firms assets are financed by a combination of debt and equity capital of varying seniority and structures</li>
<li>Obligations can be secured or unsecured, recourse or non-recourse, and of varying priority</li>
</ul>
</section>
<section>
<h2>Frictions and Transaction Costs</h2>
<ul>
<li>Asymmetric information</li>
<li>Principal-agent problems</li>
<li>Risk shifting</li>
<li>Moral hazard</li>
<li>Adverse selection</li>
<li>Externalities</li>
<li>Collective action problems/coordination failures</li>
</ul>
</section>
<section>
<h2>Default and Recovery: Analytic Concepts</h2>
<ul>
<li>Default - failure to pay on a financial obligation</li>
<li>Bankruptcy - legal procedure in which an entity seeks temporary relief from its creditors</li>
<li>Probability of default</li>
<li>Exposure at default (EAD) - amount of money lender can potentially lose in a default</li>
<li>Loss given default (LGD) = EAD - Recovery amount</li>
<li>Expected loss (EL) = Probability of default × LGD
</ul>
</section>
<section>
<h2>Assessing Creditworthiness</h2>
<ul>
<li>Credit rating - an alphanumeric grade summarizing the creditworthiness of a security or corporate entity</li>
<li>Transition matrices - show estimated likelihood of a company with a given starting rating ending a period with a different rating</li>
<li>Internal ratings</li>
<li>Credit risk models</li>
<ul>
<li>Reduced-form models - take default probability and LGD as inputs</li>
<li>Structural models - derive measures of credit risk from fundamental data</li>
<li>Factor models</li>
</ul>
</ul>
</section>
<section>
<h2>Counterparty Risk</h2>
<p><em>Definition: A special form of credit risk that arises whenever an investor requires another party to fulfill a contractual obligation and vice-versa</em></p>
<ul>
<li>Netting - having one of the parties to a contract pay only the net amount, rather than exchaning principals</li>
</ul>
</section>
<section>
<h2>The Merton Model</h2>
<ul>
<li>Assumptions:</li>
<ul>
<li>Value of assets follow geometric Brownian motion</li>
<li>Simple balance sheet</li>
<li>Limited liability/non-recourse</li>
<li>Strictly enforced contracts/no renegotiation</li>
<li>Assets of the firm are tradable</li>
<li>Default only possible at maturity</li>
<li>No interim cash flows</li>
</ul>
<li>Default occurs if the value of the firm's assets are less than its debt repayment obligations</li>
</ul>
</section>
<section>
<h2>Credit Factor Models</h2>
<p>Relate the risk of credit loss to fundamental economic variables</p>
</section>
<section>
<h2>Credit Risk Measures</h2>
<ul>
<li>Credit losses have three components:</li>
<ol>
<li>Expected loss (EL)</li>
<li>Unexpected loss (UL) - a quantile of the credit loss in excess of the expected loss</li>
<li>Tail loss - losses beyond the UL</li>
</ol>
<li>Jump-to-default risk - an estimate of the loss that would be realized if a position were to default instantly</li>
</ul>
</section>
<section>
<h1>THE END</h1>
<h3><a href="http://alchemistsacademy.com">AlchemistsAcademy.com</a></h3>
</section>
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