Credit Risk and Financial Risks Overview

Podcast

Play an AI-generated podcast conversation about this lesson

Questions and Answers

What is the default threshold ratio for long-term liabilities to short-term liabilities that indicates potential default risk?

2.0

2.5

1.0

1.5 (correct)

How is the distance to default (DD) calculated when asset prices are lognormally distributed?

σV^2 × log(expected asset value) + default threshold

expected asset value - default threshold / σexpected asset value

log(expected asset value) - log(default threshold) / σV (correct)

log(asset prices) × maturity - 2 × default threshold

What does an increased ratio of short-term liabilities to long-term liabilities indicate according to the given formulas?

Lower default risk threshold

Higher risk of immediate default (correct)

Greater buffer against economic downturns

Reduction in credit risk evaluation period

What is the formula used to compute the expected default frequency (PD) after determining the distance to default (DD)?

function of market conditions and DD Signup and view all the answers

What impact does a ratio greater than 1.5 have on the evaluation of short-term liabilities?

Increases the weight of short-term liabilities in default calculations Signup and view all the answers

What is the first step in the risk management process?

Identify the risks Signup and view all the answers

Which of the following is NOT a subtype of market risk?

Bankruptcy risk Signup and view all the answers

What does default risk pertain to in credit risk?

Non-payment of interest and/or principal on a loan Signup and view all the answers

Which step involves performing a cost-benefit analysis on risk transfer methods?

Step 3 Signup and view all the answers

What is the primary factor considered in bankruptcy risk?

Insufficient collateral value Signup and view all the answers

Which of the following methods is primarily used for evaluating credit risk?

Both quantitative and qualitative evaluation Signup and view all the answers

What does the risk mitigation strategy generally encompass?

Avoiding, transferring, mitigating, or assuming risk Signup and view all the answers

What is described as monetary losses from unhedged foreign currency positions?

Foreign exchange risk Signup and view all the answers

What does downgrade risk refer to in financial transactions?

The decrease in creditworthiness of a counterparty. Signup and view all the answers

Which of the following is an example of funding liquidity risk?

Failure to meet cash obligations to counterparties. Signup and view all the answers

What is the primary reason for the yield curve to be normally upward sloping according to liquidity preference theory?

Investors prefer immediate access to cash. Signup and view all the answers

Settlement risk occurs when which of the following happens?

A counterparty refuses to fulfill its payment obligations. Signup and view all the answers

What does trading liquidity risk refer to?

Difficulty in selling a security at market price. Signup and view all the answers

Which of the following best describes operational risk?

Risks stemming from non-financial problems within an entity. Signup and view all the answers

According to expectations theory, the yield curve's shape is most influenced by what?

Predictions of future interest rate changes. Signup and view all the answers

What is NOT a type of operational risk?

Temporary inability to find a counterparty. Signup and view all the answers

What does the shape of the yield curve indicate?

Future expected movements of interest rates Signup and view all the answers

According to market segmentation theory, what influences the slope of the yield curve?

Conditions in different segments of the market Signup and view all the answers

Which of the following is NOT a cause of credit risk?

High liquidity in the market Signup and view all the answers

What does probability of default (PD) refer to?

The chance a borrower will default on a loan Signup and view all the answers

What do qualitative techniques in credit risk evaluation assess?

The willingness of a borrower to repay their loans Signup and view all the answers

Which of the following best describes loss given default (LGD)?

The percentage loss expected if a borrower defaults Signup and view all the answers

What is one limitation of quantitative techniques in credit risk evaluation?

They depend on historical data which may not predict future performance Signup and view all the answers

Which participant is the lender in a credit agreement?

Creditor Signup and view all the answers

What represents the payment to stockholders when a firm's value is greater than its debt value in the Merton model?

Maximum of the difference between firm value and face value of debt Signup and view all the answers

Which of the following is a key assumption of the Merton model?

There is no need to adjust for liquidity Signup and view all the answers

What does the Expected Loss (EL) formula rely on to compute its value?

PD x LGD x EAD Signup and view all the answers

How is the probability of default (PD) calculated in the Merton model?

Through a cumulative normal distribution based on firm value and volatility Signup and view all the answers

Which factor is NOT included in the calculation of Altman's Z-score?

Net operating income / total liabilities Signup and view all the answers

What limitation of the Merton model is highlighted in regards to its assumptions?

The model assumes only one type of debt is issued Signup and view all the answers

Which equation from the Merton model is used for calculating the probability of default?

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

What are the 5 C’s of credit quality focused on?

Character, Capital, Capacity, Collateral, Cycle Signup and view all the answers

What issue does the KMV model specifically address compared to the Merton model?

It allows for multiple debts to mature at different times Signup and view all the answers

What is the implication of an Altman Z-score below 1.8?

The company is likely headed for bankruptcy Signup and view all the answers

What do credit rating agencies primarily use to assign ratings?

Alphanumeric grades summarizing creditworthiness Signup and view all the answers

In the Merton model, what does the 'principal amount' represent?

The exercise price of the call option Signup and view all the answers

Which of the following correctly describes the volatility ($\sigma$) referred to in the probability of default formula?

The expected changes in firm value over its lifespan Signup and view all the answers

Which of the following statements about credit scoring models is correct?

They have limitations due to the assumption of linearity. Signup and view all the answers

What does a D rating signify in credit ratings?

The entity is likely to default Signup and view all the answers

How do transition matrices help in credit risk assessment?

They provide estimated likelihoods of rating changes. Signup and view all the answers

What is the impact on default risk when the ratio of long-term liabilities to short-term liabilities is less than 1.5?

Reduced risk indicating financial stability Signup and view all the answers

Which formula correctly represents the distance to default (DD) when asset prices are lognormally distributed?

$\frac{log V - log default hreshold}{\sigma_V \times maturity}$ Signup and view all the answers

How does a high distance to default (DD) affect the probability of default (PD)?

Decreases the PD indicating less risk Signup and view all the answers

What should be inferred if a company's distance to default (DD) calculation yields a negative value?

The company is likely to default Signup and view all the answers

What does the formula for calculating the default threshold involve when the ratio exceeds 1.5?

0.3 times short-term liabilities plus adjustments for long-term liabilities Signup and view all the answers

What is the primary objective of risk management in financial contexts?

Minimize impact of financial risks Signup and view all the answers

Which step in the risk management process focuses on assessing performance and making amendments as necessary?

Assess performance and amend risk mitigation strategy Signup and view all the answers

Bankruptcy risk primarily concerns which of the following aspects?

The sufficiency of collateral during liquidation Signup and view all the answers

What is a key characteristic of default risk?

It's the risk of non-payment of interest and/or principal Signup and view all the answers

Which of the following subtypes is NOT considered a key risk class in the context of credit risk?

Commodity price risk Signup and view all the answers

In the context of evaluating credit risk, what does the qualitative assessment primarily focus on?

Borrower’s character and capacity Signup and view all the answers

What is the final step of the risk management process aimed at ensuring that strategies remain effective?

Assess performance and amend strategies Signup and view all the answers

Which of the following is a reason that makes credit risk distinct from other financial risks?

It involves a counterparty's financial obligations Signup and view all the answers

What does liquidity risk typically encompass?

The inability to pay down or refinance debt. Signup and view all the answers

Which theory suggests that longer-term financial assets should generally have a higher yield?

Liquidity preference theory. Signup and view all the answers

What kind of risk arises when a counterparty refuses to settle at the designated settlement date?

Settlement risk. Signup and view all the answers

What is primarily reflected by the shape of the yield curve according to expectations theory?

Future changes in interest rates. Signup and view all the answers

Which type of risk involves issues unrelated to financial performance, such as inadequate internal controls?

Operational risk. Signup and view all the answers

Why might short-term interest rates be higher than long-term ones according to expectations theory?

Investors prefer cash now and expect lower rates in the future. Signup and view all the answers

Which of the following best describes funding liquidity risk?

Failing to satisfy cash obligations to counterparties. Signup and view all the answers

What does the market segmentation theory suggest about the behavior of major investors?

Investors are confined to a specific segment and do not switch. Signup and view all the answers

Which of the following correctly defines credit risk?

The probability that a borrower will not repay a loan as agreed. Signup and view all the answers

What does Loss Given Default (LGD) represent?

The percentage loss the lender faces if the borrower defaults. Signup and view all the answers

Which of the following is a limitation of qualitative techniques in credit risk evaluation?

The subjectivity involved in assessment can introduce bias. Signup and view all the answers

What does the term 'exposure at default' (EAD) refer to in credit risk?

The dollar amount that could be lost at the time of default. Signup and view all the answers

Which technique is used to assess a borrower's willingness to repay a loan?

Interviews and information gathering. Signup and view all the answers

What effect can government policy have on interest rates according to the content?

High interest rate policies can force short-term rates to exceed long-term rates. Signup and view all the answers

Which of the following best describes credit risk evaluation's focus on probability of default (PD)?

PD assesses the likelihood of a borrower defaulting on payments. Signup and view all the answers

What factors are combined to calculate the expected loss (EL)?

Probability of Default, Loss Given Default, Exposure at Default Signup and view all the answers

Which of the following is true regarding Altman's Z-score?

It includes elements of profitability, liquidity, and solvency. Signup and view all the answers

What is a characteristic of credit scoring models?

They assign a numerical value indicating default likelihood. Signup and view all the answers

What does a D credit rating signify?

The entity has a high likelihood of default. Signup and view all the answers

Which of the following factors is NOT part of the '5 C's of credit quality'?

Cost Signup and view all the answers

What does a transition matrix provide in the context of credit ratings?

Shows the likelihood of a rating change within a specified period. Signup and view all the answers

Which limitation is associated with credit scoring models?

They may assume linear relationships among variables. Signup and view all the answers

What is the primary purpose of using a rating system in credit risk assessment?

To summarize creditworthiness of securities or entities. Signup and view all the answers

What is the main limitation of the Merton model in relation to its assumptions?

It assumes the only debt is in the form of zero-coupon bonds. Signup and view all the answers

In the Merton model, how is the payment to stockholders calculated when the firm's value exceeds its debt value?

max(VM - FM, 0) Signup and view all the answers

What does the 'prove of default' (PD) formula rely on in the Merton model?

The cumulative normal distribution and firm value dynamics. Signup and view all the answers

What does the KMV model improve upon when compared to the Merton model?

It considers multiple debt issues maturing at different times. Signup and view all the answers

In the Merton model's probability of default (PD) calculation, what does 'σ' represent?

The volatility of firm value. Signup and view all the answers

Which equation in the Merton model closely resembles the equation used to compute probability of default (PD)?

PD = N(-d2) Signup and view all the answers

What does the assumption of a constant risk-free interest rate imply in the Merton model?

Market conditions will not affect the firm's valuation. Signup and view all the answers

Which statement best describes the nature of debt according to the Merton model?

Debt is viewed as a liability that may be defaulted on. Signup and view all the answers

Study Notes

Credit Risk

Credit risk is the probability that a borrower will not repay a loan according to the agreed terms.
Key participants include the borrower (obligor, counterparty), and the lender (creditor, obligee).
Credit risk can result from:
- Default on a financial obligation
- Increased probability of default
- More severe loss than expected due to higher exposure at the time of default
- More severe loss than expected due to lower recovery at the time of default
- Default on payment for goods or services already delivered (settlement risk)

Financial Risks: A Helicopter View

Financial risks are categorized for overview.
The risk management process has five steps:
- Identifying risks
- Quantifying and estimating risk exposure or determining appropriate risk transfer methods
- Determining the collective effects of risks or performing a cost-benefit analysis on risk transfer methods
- Creating a risk mitigation strategy (avoid, transfer, mitigate, or accept)
- Assessing performance and adjusting the risk mitigation strategy as needed.

Key Risk Classes

Market Risk: considers how changes in market prices and rates lead to investment losses.
- Subtypes:
  - Interest rate risk: the risk that an investment's value changes due to interest rate fluctuations (absolute level, spread between rates, yield curve shape).
  - Equity price risk: general market risk and entity-specific risks (unique factors impacting the entity).
  - Foreign exchange risk: monetary losses arising from unhedged or partially hedged foreign currency dealings.
  - Commodity price risk: price volatility of commodities (metals, agriculture, energy, etc.).
Credit Risk: a loss if a counterparty fails to meet financial obligations defined by a contract.
- Subtypes:
  - Default risk: non-payment of interest and/or principal on a loan.
  - Bankruptcy risk: insufficient collateral value to cover losses from default.
  - Downgrade risk: decreased creditworthiness due to recent financial performance.
  - Settlement risk: the risk that a party will not fulfil payment obligations at the settlement date.
Liquidity Risk: the inability to meet obligations due to insufficient cash or easily transferrable assets.
- Subtypes:
  - Funding liquidity risk: difficulty meeting debt payments or refinancing.
  - Trading liquidity risk: inability to buy or sell securities at market price due to a lack of counterparties.
Operational Risk: risk from non-financial factors.
- This includes: inadequate computer systems, poor internal controls, incompetent management, fraud, human error, and natural disasters.

Term Structure of Interest (Yield Curve)

The term structure of interest (yield curve) is the relationship between interest rates and debt instruments with varying maturities.
Interest rates change on a debt security or loan depending on maturity.
Liquidity preference theory suggests that long-term investments offer higher yields to compensate for their reduced liquidity compared to short-term investments.
Expectations theory suggests that current interest rates reflect expectations for future interest rate changes.
Market Segmentation theory suggests that different market segments have varying investment preferences and expectations. Government policy also influences interest rates.

Credit Risk: A Broader View

Credit Risk Evaluation: Qualitative and quantitative methods.
- Qualitative: assesses willingness to pay through face-to-face meetings, info gathering, etc. (SUBJECTIVE)
- Quantitative: assesses capacity to pay using financial statements analysis. (LIMITATIONS: historical data, projections)
Probability of Default (PD): Likelihood a borrower will default; a probability of default.
Loss Given Default (LGD): Expected percentage loss if a borrower defaults; percentage of loss given default.
Exposure at Default (EAD): Monetary value of the loan or maximum credit limit.
Expected Loss (EL): Calculated by multiplying PD, LGD, and EAD.
Time Horizon (Tenor): Longer periods mean greater lender risk.

Methods for Computing Default Risk

Expert System: assessing credit quality based on the 5Cs (character, capital, capacity, collateral, cycle).
Credit Scoring Models (Beaver, Altman): numerical values to predict default likelihood, often used for small/private firms (limitations: linearity, balance-sheet data). Altman's Z-score is a linear discriminant analysis used widely.
Option-Theoretic Models (e.g., Merton Model): models based on option pricing theory, used to estimate default probability. Merton models consider a single zero-coupon bond issue; the firm’s assets are the underlying assets.
KMV Model: addresses limitations of the Merton model by considering multiple debt maturities and more realistic economic factors. Calculating a default threshold according to the ratio of long-term and short-term liabilities to determine the likelihood of the business defaulting.
Distance to Default (DD): measures the difference between expected asset value and default threshold in calculating the probability of default in KMV models.
Rating Systems: Credit rating agencies assign alphanumeric grades representing creditworthiness of securities or entities. AAA is the highest rating, and D is indicative of default. There are important transition matrices that depict the probability of a rating change over time; showing the likelihood of rating migrations.

Studying That Suits You

Use AI to generate personalized quizzes and flashcards to suit your learning preferences.

Description

This quiz covers the fundamentals of credit risk, focusing on the roles of borrowers and lenders. It explores various aspects of financial risks, including risk identification, exposure estimation, and mitigation strategies. Test your knowledge on these essential financial concepts!