FINC629

Credit Risk Management

Dr. Huong Dieu Dang
huong.dang@canterbury.ac.nz
Skype: FINC311_FINC652_UC

1
Financial risk categories
Risk is the volatility of unexpected outcomes (business
risk, financial risk, legal risk, etc.)
Risk faced by bondholders:
Credit risk: default risk, credit downgrade risk, credit spread risk
Interest rate risk
Yield curve risk
Call and reinvestment risk
Prepayment risk
Liquidity risk
Inflation risk
Volatility risk
Sovereign risk
Event risk


2
Default Risk
Default risk is the risk that the issuer will fail to satisfy the
terms of the bond obligation with respect to the timely
payment of principal and interest.

The percentage of a population of bonds that is expected
to default is called the default rate.

A default does not mean the investor loses the entire
amount invested, a percentage of the investment may be
recovered. This is referred to as the recovery rate.

Credit Spread Risk
In the U.S. the Treasury security with the same maturity as the risky bond
being evaluated is considered to be risk-free.
The yield on a bond is made up of two components:
The yield on a similar default (risk-free) bond
A premium above the yield on a default-free bond to compensate for the
additional risk of the bond (risk premium)
The risk that the price
an issuers bonds will
decline due to an
increase in the credit
spread is called the
credit spread risk.

The credit spread
trends to increase
during recessions and
decrease during
economic expansions.

Downgrade Risk
The quality of any bond is based on the issuer's financial
ability to make interest payments and repay the loan in
full at maturity.
Bond Ratings: The bond's credit rating is the first
indication of the bond's quality.
Third-party ratings such as Standard and Poor's (S&P),
Moody's, and Fitch assign ratings to bonds, which reflect
their evaluation of the creditworthiness of an issuer.




Credit ratings scales
S&P ratings
AAA
AA+, AA, AA-
A+, A, A-
BBB+, BBB, BBB-
BB+, BB, BB-
B+, B, B-
CCC+, CCC, CCC-
CC
C
D (default)

Moodys ratings
Aaa
Aa1, Aa2, Aa3
A1, A2, A3
Baa1, Baa2, Baa3
Ba1, Ba2, Ba3
B1, B2, B3
Caa1, Caa2, Caa3
Ca
C
Investment
grade ratings
Speculative
(junk) grade
ratings
6
Interest rate risk
7
Prices and yields
(required rates of
return) have an inverse
relationship
The bond price curve
is convex.
Progressive
increases in the
interest rate result
in progressive
smaller reductions
in the bond prices

Yield Curve Risk Parallel Shift
The yield curve is
actually a series of
yields, one for each
maturity.
Duration can be used on
a portfolio of fixed
income securities to
understand the
approximate change in a
portfolios value for a 100
basis point change in the
yield for all maturities.

Duration is a measure of
the effective maturity of a
bond

Duration =
| | Price ) 1 ( y
CF w
t
t t
+ =
t w t D
T
t

=
=
1
Yield Curve Risk Nonparallel Shift
To determine the impact of interest rate risk on a portfolio of bonds with differing
maturities, a rate duration is computed to measure the impact of a rate change in at
particular maturity
20
Example of Measuring Price Sensitivity to
Yield Change
Percentage Price Change for four hypothetical Bonds
Initial yield for all bonds is 6%.
Percent Price Change
New Yield 6% 5 year 6% 20 year 9% 5 year 9% 20 year
4.00 8.98 27.36 8.57 25.04
5.00 4.38 12.55 4.17 11.53
5.50 2.16 6.02 2.06 5.54
5.90 0.43 1.17 0.41 1.07
5.99 0.04 0.12 0.04 0.11
6.01 -0.04 -0.12 -0.04 -0.11
6.10 -0.43 -1.15 -0.41 -1.06
6.50 -2.11 -5.55 -2.01 -5.13
7.00 -4.16 -10.68 -3.97 -9.89
8.00 -8.11 -19.79 -7.75 -18.4


Greatest change for lower coupon,
longer maturity, lower yield
Risks faced by bond holders (cont.)
Call and reinvestment risk
The cash flow pattern of a callable bond is not known with
certainty because it is not known when the bond will be
called.
Falling interest rates may prevent bond coupon payments
from earning the same rate of return as the original bond.
The price appreciation potential of the bond will be reduced
relative to a comparable option-free bond.
Prepayment rate:
Investors in mortgage- and asset-backed bonds face the risk
that the borrower can prepay principal prior to scheduled
principal payment dates


11
Call and prepayment risk (cont.)
12
If interest rates fall, price
of straight bond can rise
considerably.
The price of the callable
bond is flat over a range
of low interest rates
because the risk of
repurchase or call is high.
When interest rates are
high, the risk of call is
negligible and the values
of the straight and the
callable bond converge.

Risk faced by bond holders (cont.)
Liquidity risk
Liquidity risk is the risk that the investor will have to sell
the bond below its indicated value, where the indication is
revealed by a recent transaction.
The primary measure of liquidity is the size of the spread
between the bid price (what the dealer is willing to pay)
and the ask price (what the dealer is willing to sell).
A liquid market is generally defined by a small bid-ask
spread which does increase materially for large
transactions
Inflation risk
Inflation or purchasing power risk arises from the decline in
the value of a bonds cash flows due to inflation.


13
Risk faced by bond holders (cont.)
Volatility risk
The risk that the price of a bond with an embedded option
will decrease when expected yield volatility changes.
Basic option valuation: The price of an option increases
with more volatility of the underlying asset, all things
equal.
Therefore, changing yield volatility affects the price of a
bond with an embedded option
The greater the expected yield volatility, the greater the value
(price) of an option.


14
Risk faced by bond holders (cont.)
Sovereign risk: The risk that, as the result of the
actions of a foreign government, there may be either a
default or an adverse price change even in the absence of a
default
Currency revaluations, political change, or war can result in
a change in credit risk
Sovereign risk has two components:
Unwillingness of a foreign government to pay principal
or interest
The inability of a foreign government to pay

15
Sovereign local currency debts default
Country Default date
Rating one year
before default
Argentina 11/6/01 BBB-
Dominican Republic 4/9/99 BB
Ecuador 12/15/08 B-
Jamaica 1/14/10 B
Suriname 1/1/00
Grenada 1/1/05 BB-
Grenada 12/1/06 B-
Cameroon 1/09/2004 B
16
Sovereign foreign currency debt default
Country Default date
Rating one year before
default
Argentina 11/6/01 BB
Belize 12/7/06 CCC-
Dominican Republic 2/1/05 CCC
Ecuador 12/15/08 B-
Grenada 12/30/04 BB-
Indonesia, first default 3/29/99 B-
Indonesia, second default 4/17/00
CCC+
Indonesia, third default 4/23/02 B-
Jamaica 1/14/10 B
Pakistan 1/29/99 B+
Paraguay 2/13/03 B
Russia 1/27/99 BB-
Seychelles 8/7/08 B
Uruguay 5/16/03 BB-
Venezuela 1/18/05 B-
17
Risk faced by bond holders (cont.)
Event risk:
Occasionally an issuer is unable to make either interest
or principal payments because of unexpected events,
such as a natural catastrophe or disaster, a corporate
takeover or restructuring, or a regulatory change

18
Drivers of credit risks
Default probability p:
A counterparty fails to make contractually promised
interest/ principal payments or to comply with other
conditions of the debt agreement
The present value of its assets is smaller than the present
values of its liabilities
It files for bankruptcy
Credit exposure (CE) / exposure at default (EAD): The
economic or market value of the claim on the counterparty
Loss given default (LGD): the fractional loss due to default
LGD=1-recovery rate
19
Default distribution for a single loan
Let us assume that
There are only two possible states: default / no default
Probability of default =p
EAD=1$
LGD=100%
We start with a portfolio containing only one loan:


p
Default
no default
credit event probability
1 p
loan
Distribution of credit losses







0
1
1-p
p
CL
20
Default distribution for independent loans
If default events are statistically independent
p(A and B)=p(A) * p(B)
Example: Three loans with PD = p (independent)
Prob(loan 1 defaults; others do not): p(1-p)
2
Prob(exactly one loan defaults) = 3*p(1-p)
2
1=p
3
+3p
2
(1-p)+3p (1-p)
2
+(1-p)
3

In general: binomial distribution:
E(x) = N*p
Var(x) = N*p(1-p)
Prob(exactly n defaults from N loans) =
Where
(1 )
n N n
N
p p
n

| |

|
\ .
!
!( )!
N
N
n n N n
| |
=
|

\ .
21
Default distributions for dependent loans
If default events are not independent, the probability
of join default, p(A and B), depends on the marginal
probabilities and correlation



Example 1. The correlation=0.5, and p(A)=p(B)=0.01

| | | | | |
,
( ) ( )
A B A B A B A B
E b b Cov b b E b E b p A p B o o ( = + = +

| |
(1 ) (1 ) ( ) ( )
A B A A B B
E b b p p p p p A p B = +
A B Default No default Marginal
Default 0.00505 0.00495 0.01
No default 0.00495 0.98505 0.99
Marginal 0.01 0.99
22
Measuring Credit Losses
The distribution of credit losses (CL) due to
default from a portfolio of N loans granted by
different obligors


Where b
i
is a Bernoulli random variable that takes the
value of 1 if default occurs and 0 otherwise.

If the drivers of credit risks are independent



1
N
i i i
i
CL b EADLGD
=
=

| |
i i
E b p =
| | | | | |
1
N
i i i
i
E CL p E EAD E LGD
=
=

23
Measuring credit losses (cont.)
Assume that (i) all creditors have the same distribution of p and
LGD; and (ii) EAD are the same (EAD =1$)
The expected credit loss is linear in the default probability p

where n is the number of actual losses
Standard deviation of credit loss and probability of default p
have non-linear relationship


The dispersion of credit loss (SD[CL]) is greater than the
expected loss (E[CL]) for higher default rate p






| | | | | | | | | |
( )
i
E CL E n E EAD E LGD Np E LGD = =
| | | | | | | | | |
2 2
{ } { } SD CL E n V LGD V n E LGD = +
| | | | | |
2
{ } (1 ){ } SD CL NpV LGD Np p E LGD = +
24
Credit risk diversification
Concentration risk: too many defaults could occur at the same
time (defaults are highly correlated)
Defaults are more highly correlated within sectors than across sectors
Defaults occur more often during recession than during expansion
Financial institutions achieve diversification by concentration
limits
Limit the extent of exposure to a particular industrial or geographical
sector
The distribution of the sum of independent variables tends to be
a normal distribution
A portfolio of consumer loans, which spreads over a large number of
counterparties, is less risky than a comparable portfolio of corporate loans

25
Example 2
A portfolio of N equal loans with total value of $100 mio.
Defaults are statistically independent (correlation=0). Loans
have equal probability of default p=1%. LGD=100%
N=1
Expected loss (EL)=0.01*100mio+0.99*0=1mio
SD ={0.01*0.99*1*(100mio)^2}
1/2
=9.94 mio
Highly skewed distribution
N=10

N=100

26
| | | | | |
2
{ } (1 ){ } SD CL NpV LGD Np p E LGD = +
Example 3
A portfolio with 3 bonds A, B, C
Assume:
Exposures are constant
Recovery rate if default occurs is zero
Default events are independent across the three issuers




Expected loss=$13.25

Issuer Exposure Probability
A $25 0.05
B $30 0.1
C $45 0.2
27
Example 3 (cont.)
Default i Loss
CL
i
Probability
p
i

Cumulative
probability
Expected loss
EL
i
= CL
i
*p
i

Variance
p
i
*(CL
i
EL )
2

None $0 0.6840 0.684 $0 0.684*(0-13.25)
2

=120.08
A $25 0.0360 0.72 $0.9 0.036*(25-13.25)
2
=4.97


B $30 0.0760 0.796 $2.28 0.076*(30-13.25)
2
=21.32
C $45 0.171 0.967 $7.695 0.171*(45-13.25)
2
=172.38
A and B $55 0.004 0.971 $0.22 0.004*(55-13.25)
2
=6.97
A and C $70 0.009 0.98 $0.63 0.009*(70-13.25)
2
=28.99
B and C $75 0.019 0.999 $1.425 0.019*(75-13.25)
2
=72.45
A and B and C $100 0.001 1 $0.1 0.001*(100-13.25)
2
=7.53
Sum EL=$13.25 434.7
SD=(434.7)
1/2
=$20.9
-> CL
i
=$45
Unexpected loss with a 95% quantile = 45-13.25=$31.75

( ) 95%
i
P CL CL s >
28
Expected loss vs. unexpected loss
losses
p
r
o
b
a
b
i
l
i
t
y

d
e
n
s
i
t
y
Expected loss
95% quantile (Value at Risk)
(time horizon: 1 year)
Unexpected loss
The portfolio distribution is usually described through:
Expected Loss (EL)
o% quantiles: loss which exceeds o% of all possible losses (credit VaR or total loss )
Unexpected Loss = credit VaR EL=$31.75
The expected credit loss depends on individual default probabilities but not on default correlation
The higher the default correlation the higher the unexpected credit loss
$13.25 $45
29
Credit risk vs market risk
Credit risk
Sources: Default risk, recovery
risk, market risk (EAD)
Distribution: Strongly skewed
to the left
Time horizon (corrective
actions): Long term (years)
Legal issues: Very important
Risk aggregation: Whole firm
vs. counterparty
Market risk
Sources: Market risk

Distribution : Mainly
symmetrical, fat tails
Time horizon: short term
(days)
Legal issues: Not applicable
Risk aggregation: Business/
Trading unit
30
Example 4 (Jorion, p. 463, 19.7)
A portfolio consists of two bonds. The credit VAR is
defined as the maximum loss due to defaults at a
confidence level of 98% over a one-year horizon.
The probability of joint default of the two bonds is
1.27%, and the default correlation is 30%. The bond
value, default probability, and recovery rate for
bond A are $1 mio, 3% and 60%, and for bond B are
$600,000, 5% and 40%
What is the expected credit loss of the portfolio?

31
Example 5 (Jorion, p. 463, 19.8)





A B Default No default Marginal
Default 0.0127 0.0173 0.03
No default 0.0373 0.9327 0.97
Marginal 0.05 0.95 1
Default i Loss CL
i
Probability
p
i

Cumulative
probability
Expected loss
EL
i
= CL
i
*p
i

Variance
p
i
*(CL
i
EL )
2

None $0 0.9327 0.9327 0
B $0.36 mio 0.0373 0.97 ?
A $0.4mio 0.0173 0.9873 ?
A and B 0.76mio 0.0127 1 ?
Sum $30,000
What is the best estimate of the unexpected credit loss for this portfolio?
400000-30000=$370000
32
Example 6 (Jorion, p. 468, 19.11)
A portfolio of bonds consists of five bonds whose default
correlation is zero. The one- year probabilities of default of
the bonds are 1%, 2%, 5%, 10%, and 15%. What is the one-
year probability of no default within the portfolio?

33
Example 7 (Jorion, p. 468, 19.12)
There are 10 bonds in a credit default swap
basket. The probability of default for each of
the bond is 5%. The probability of any one
bond defaulting is completely independent of
what happens to the other bonds in the
basket. What is the probability that exactly
one bond defaults?

34
Example 8 (Jorion, p. 458, 19.4)
A bank has booked a loan with total
commitment of $50,000 of which 80% is
currently outstanding. The default probability
of the loan is assumed to be 2% for the next
year, and loss given at default is estimated at
50%. The standard deviation of loss given at
default is 40%. Drawdown on default (i.e. the
fraction of the undrawn loan) is assumed to
be 60%. Calculate the expected and
unexpected losses (standard deviation)
35
Example 8 (cont.)
EAD=80%*50,000+60%*(20%*50,000)=$46,000
EL= $460
V[CL]=pV[LGD]+p(1-p){E[LGD]}
2

V[CL]=0.0810
SD[CL]=0.09
Unexpected loss=$4,140
36
Example 9 (Jorion, p. 464, 19.10)
Consider an A-rated bond and a BBB-rated bond.
Assume that the one-year probabilities of default for
the A- and BBB-rated bonds are 2% and 4%
respectively, and that the joint probability of default
of the two bonds is 0.15%. What is the default
correlation between the two bonds?
Probability of joint default

| |
(1 ) (1 ) ( ) ( )
A B A A B B
E b b p p p p p A p B = +
37