Credit Risk and Financial Risks Overview

<p>function of market conditions and DD (D)</p> Signup and view all the answers

<p>Increases the weight of short-term liabilities in default calculations (A)</p> Signup and view all the answers

<p>Identify the risks (B)</p> Signup and view all the answers

<p>Bankruptcy risk (C)</p> Signup and view all the answers

<p>Non-payment of interest and/or principal on a loan (C)</p> Signup and view all the answers

<p>Step 3 (D)</p> Signup and view all the answers

<p>Insufficient collateral value (A)</p> Signup and view all the answers

<p>Both quantitative and qualitative evaluation (A)</p> Signup and view all the answers

<p>Avoiding, transferring, mitigating, or assuming risk (A)</p> Signup and view all the answers

<p>Foreign exchange risk (D)</p> Signup and view all the answers

<p>The decrease in creditworthiness of a counterparty. (A)</p> Signup and view all the answers

<p>Failure to meet cash obligations to counterparties. (B)</p> Signup and view all the answers

<p>Investors prefer immediate access to cash. (C)</p> Signup and view all the answers

<p>A counterparty refuses to fulfill its payment obligations. (B)</p> Signup and view all the answers

<p>Difficulty in selling a security at market price. (B)</p> Signup and view all the answers

<p>Risks stemming from non-financial problems within an entity. (A)</p> Signup and view all the answers

<p>Predictions of future interest rate changes. (C)</p> Signup and view all the answers

<p>Temporary inability to find a counterparty. (D)</p> Signup and view all the answers

<p>Future expected movements of interest rates (C)</p> Signup and view all the answers

<p>Conditions in different segments of the market (C)</p> Signup and view all the answers

<p>High liquidity in the market (B)</p> Signup and view all the answers

<p>The chance a borrower will default on a loan (C)</p> Signup and view all the answers

<p>The willingness of a borrower to repay their loans (C)</p> Signup and view all the answers

<p>The percentage loss expected if a borrower defaults (D)</p> Signup and view all the answers

<p>They depend on historical data which may not predict future performance (C)</p> Signup and view all the answers

<p>Creditor (A)</p> Signup and view all the answers

<p>Maximum of the difference between firm value and face value of debt (D)</p> Signup and view all the answers

<p>There is no need to adjust for liquidity (D)</p> Signup and view all the answers

<p>PD x LGD x EAD (C)</p> Signup and view all the answers

<p>Through a cumulative normal distribution based on firm value and volatility (D)</p> Signup and view all the answers

<p>Net operating income / total liabilities (B)</p> Signup and view all the answers

<p>The model assumes only one type of debt is issued (C)</p> Signup and view all the answers

<p>$PD = \frac{ln F - ln V - \mu (T - t) + 0.5\sigma^2 (T - t)}{\sigma (T - t)}$ (A)</p> Signup and view all the answers

<p>Character, Capital, Capacity, Collateral, Cycle (C)</p> Signup and view all the answers

<p>It allows for multiple debts to mature at different times (A)</p> Signup and view all the answers

<p>The company is likely headed for bankruptcy (A)</p> Signup and view all the answers

<p>Alphanumeric grades summarizing creditworthiness (B)</p> Signup and view all the answers

<p>The exercise price of the call option (C)</p> Signup and view all the answers

<p>The expected changes in firm value over its lifespan (D)</p> Signup and view all the answers

<p>They have limitations due to the assumption of linearity. (D)</p> Signup and view all the answers

<p>The entity is likely to default (D)</p> Signup and view all the answers

<p>They provide estimated likelihoods of rating changes. (D)</p> Signup and view all the answers

<p>Reduced risk indicating financial stability (B)</p> Signup and view all the answers

<p>$\frac{log V - log default hreshold}{\sigma_V \times maturity}$ (C)</p> Signup and view all the answers

<p>Decreases the PD indicating less risk (A)</p> Signup and view all the answers

<p>The company is likely to default (B)</p> Signup and view all the answers

<p>0.3 times short-term liabilities plus adjustments for long-term liabilities (D)</p> Signup and view all the answers

<p>Minimize impact of financial risks (D)</p> Signup and view all the answers

<p>Assess performance and amend risk mitigation strategy (B)</p> Signup and view all the answers

<p>The sufficiency of collateral during liquidation (C)</p> Signup and view all the answers

<p>It's the risk of non-payment of interest and/or principal (A)</p> Signup and view all the answers

<p>Commodity price risk (C)</p> Signup and view all the answers

<p>Borrower’s character and capacity (D)</p> Signup and view all the answers

<p>Assess performance and amend strategies (B)</p> Signup and view all the answers

<p>It involves a counterparty's financial obligations (D)</p> Signup and view all the answers

<p>The inability to pay down or refinance debt. (C)</p> Signup and view all the answers

<p>Liquidity preference theory. (B)</p> Signup and view all the answers

<p>Settlement risk. (D)</p> Signup and view all the answers

<p>Future changes in interest rates. (D)</p> Signup and view all the answers

<p>Operational risk. (D)</p> Signup and view all the answers

<p>Investors prefer cash now and expect lower rates in the future. (C)</p> Signup and view all the answers

<p>Failing to satisfy cash obligations to counterparties. (B)</p> Signup and view all the answers

<p>Investors are confined to a specific segment and do not switch. (A)</p> Signup and view all the answers

<p>The probability that a borrower will not repay a loan as agreed. (C)</p> Signup and view all the answers

<p>The percentage loss the lender faces if the borrower defaults. (C)</p> Signup and view all the answers

<p>The subjectivity involved in assessment can introduce bias. (A)</p> Signup and view all the answers

<p>The dollar amount that could be lost at the time of default. (A)</p> Signup and view all the answers

<p>Interviews and information gathering. (B)</p> Signup and view all the answers

<p>High interest rate policies can force short-term rates to exceed long-term rates. (D)</p> Signup and view all the answers

<p>PD assesses the likelihood of a borrower defaulting on payments. (C)</p> Signup and view all the answers

<p>Probability of Default, Loss Given Default, Exposure at Default (B)</p> Signup and view all the answers

<p>It includes elements of profitability, liquidity, and solvency. (C)</p> Signup and view all the answers

<p>They assign a numerical value indicating default likelihood. (C)</p> Signup and view all the answers

<p>The entity has a high likelihood of default. (B)</p> Signup and view all the answers

<p>Cost (A)</p> Signup and view all the answers

<p>Shows the likelihood of a rating change within a specified period. (D)</p> Signup and view all the answers

<p>They may assume linear relationships among variables. (A)</p> Signup and view all the answers

<p>To summarize creditworthiness of securities or entities. (A)</p> Signup and view all the answers

<p>It assumes the only debt is in the form of zero-coupon bonds. (D)</p> Signup and view all the answers

<p>max(VM - FM, 0) (C)</p> Signup and view all the answers

<p>The cumulative normal distribution and firm value dynamics. (A)</p> Signup and view all the answers

<p>It considers multiple debt issues maturing at different times. (B)</p> Signup and view all the answers

<p>The volatility of firm value. (D)</p> Signup and view all the answers

<p>PD = N(-d2) (B)</p> Signup and view all the answers

<p>Market conditions will not affect the firm's valuation. (B)</p> Signup and view all the answers

<p>Debt is viewed as a liability that may be defaulted on. (C)</p> Signup and view all the answers

The potential loss a party faces when a counterparty fails to fulfill financial obligations.

The risk that a borrower will not pay interest or principal on a loan.

The risk that the assets of a borrower are insufficient to cover the total amount owed on default.

A series of steps used to identify, quantify, mitigate, and monitor financial risks.

The first step of risk management where financial risks are recognized.

Estimating possible financial losses from various risks.

A plan to reduce or avoid financial risks.

Step to monitor and evaluate the effectiveness of risk mitigation.

A decreased creditworthiness of a counterparty in a financial transaction, based on recent financial performance.

The risk that a counterparty fails to pay as agreed at the settlement date of a financial transaction.

The risk an entity might not be able to buy or sell assets or meet cash obligations quickly and easily.

The risk that an entity cannot pay its debts, meet cash obligations, or pay withdrawals.

The inability to readily buy or sell a security at the desired market price due to lack of counterparties.

The risk associated with non-financial issues such as inadequate systems, poor controls, management errors, fraud, human errors, and disasters.

A graphical representation of the relationship between interest rates and the maturities of debt instruments.

A theory explaining why long-term financial assets typically have higher yields than short-term ones, because investors prefer immediate cash.

The shape of the yield curve reveals market expectations about future interest rate movements.

This theory suggests that different segments of the market have their own unique investors who are unlikely to switch segments, even if interest rate forecasts change.

Government policies on interest rates can directly influence the shape of the yield curve.

Who plays which role in credit agreements?

Assessing a borrower's willingness and ability to repay a loan.

The likelihood that a borrower will fail to make payments on a loan.

The estimated percentage loss if a borrower defaults on a loan.

A method to determine when a company is likely to default based on its short-term and long-term liabilities.

The specific point or value where the ratio of long-term liabilities to short-term liabilities triggers a potential default.

A metric calculating the distance between a company's current asset value and the default point.

The probability that a company will default on its debt obligations within a specific time period.

A statistical distribution where the logarithm of a random variable follows a normal distribution, commonly used for asset prices.

Exposure at Default - The amount of money a lender is exposed to at the time a borrower defaults. It can be expressed as a percentage of the loan or the maximum amount available on a credit line.

The estimated amount a lender expects to lose from a loan default. It's calculated by multiplying the Probability of Default (PD), Loss Given Default (LGD), and Exposure at Default (EAD).

The length of time a loan agreement is in effect. A longer tenor means a greater risk to the lender.

A framework used to assess a borrower's creditworthiness. They include: Character, Capital, Capacity, Collateral, and Cycle.

Models that assign a numerical value to a firm based on financial data, predicting its likelihood of default. Often used for smaller businesses.

A financial tool used to predict bankruptcy risk. It uses five financial ratios to calculate a score, with lower scores indicating higher risk.

A system used by credit rating agencies to assess the creditworthiness of securities or entities. It uses alphanumeric grades, with AAA being the highest and D signifying default.

Changes in a company's credit rating over time. It's analyzed using transition matrices, which show the probability of a rating change within a specific time period.

It's a structural model that uses option pricing theory to determine the probability of a company defaulting on its debt. It views the firm's debt as a put option and equity as a call option.

The Merton model assumes that a company's assets follow a lognormal distribution, meaning that the logarithm of the asset value is normally distributed.

The formula for calculating PD is derived from the Black-Scholes-Merton (BSM) option pricing model and uses the cumulative normal distribution function. It relates the firm's value, face value of the debt, maturity, volatility, and risk-free rate.

The Merton model assumes a simplified financial structure (one debt issue and one equity issue) and ignores multiple debt maturities, complex capital structures, and the possibility of negotiations between debt and equity holders.

The KMV model addresses some of the Merton model's limitations by using historical data and market information to estimate the firm's value, considering multiple debt instruments, and allowing for flexibility in the debt maturity structure.

The Merton model assumes a lognormal distribution for asset values and relies on theoretical assumptions, while the KMV model uses market data and historical information to estimate the probability of default.

N represents the cumulative normal distribution function, which calculates the probability that a random variable (like asset value) will be less than or equal to a given value. It is essential for calculating the chances of default.

The PD formula is the core of the Merton model, allowing us to calculate the probability of default at a specific point in time based on the firm's current value, debt structure, and market conditions. This is a key input for risk management and credit analysis.

The process of deciding whether or not to extend credit to a borrower.

Using financial data and models to assess credit risk.

Using non-financial factors to assess credit risk, like the borrower's reputation or management quality.

Quantifying the potential loss from credit risk.

The relationship between interest rates and the maturities of debt instruments.

The belief that interest rates reflect expectations of future changes in interest rates, influencing the shape of the yield curve.

The loss exposure may be stated as a dollar amount. It represents the amount of money a lender is exposed to at the time a borrower defaults.

The point at which a company is considered likely to default, determined by the ratio of its long-term and short-term liabilities.

DD is used to calculate PD. A larger DD indicates a lower PD, meaning the company is less likely to default.

A structural model that uses option pricing theory to determine the probability of a company defaulting on its debt. It views the firm's debt as a put option and equity as a call option.

The Merton model uses the Black-Scholes-Merton (BSM) option pricing model to calculate the probability of default. It uses the firm's value, face value of the debt, maturity, volatility, and risk-free rate.

The Merton model assumes a simplified financial structure where there is only one debt issue and one equity issue, the debt is in the form of a zero-coupon bond, and default can only occur at the maturity date. It also assumes that the value of the firm is observable and follows a lognormal distribution, the risk-free interest rate is constant through time, and there is no negotiation between equity and bondholders.

The KMV model addresses some of the Merton model's limitations by using historical data and market information to estimate the firm's value. It considers multiple debt instruments and allows for flexibility in the debt maturity structure.

The Merton model assumes a lognormal distribution for asset values and relies on theoretical assumptions. The KMV model uses market data and historical information to estimate the probability of default.