Financial institutions have to comply with strict rules to limit risk. For their internal management they also need better measures of risk. For instance, the limit system is adequate only if the risk measures are correct. For derivatives, the usage of risk limits is difficult to measure. The notional does not represent the actual exposure.
Credit Risk Time Profiles The time profiles of add-ons for swaps have different shapes. When the last flows are the most important, the risk usually increases with time because of the effect of increased volatility of this last flow. This is the usual profile of currency swaps. When amortizing effects are important, the number of […]
Collaterals are assets that the lender seizes and sells if the borrower fails to perform his debt obligations. The original credit risk turns into a recovery risk plus an asset value risk. Collateral is also an incentive for the borrower to fulfil debt obligations effectively, mitigating moral hazard in lending. Should he fail in his […]
Third-party protections include guarantees, support of a parent company, insurance and protection against credit risk from the seller of credit derivatives. The latter is a much newer concept than the others, and has different characteristics detailed in subsequent chapters (58 and 59).
Covenants are obligations for borrowers and options for lenders. Covenant breaches trigger prompt repayment of outstanding debt, making it mandatory for the borrower to renegotiate with the lender for continuing operations. The borrower needs a waiver to continue operations. A breach in a covenant is, for instance, a ratio falling below a threshold value, such […]
Structured finance designates all specialized finance where credit risk is entirely dependent on a structure resiliency, the ability of this dedicated entity to sustain stressed conditions, rather than on the credit standing of a firm. The lender is not at risk with a counterparty that is a firm, as usual, but with an entity that […]
In addition to being a major ingredient of loss under default, the recovery rate serves to calculate expected loss, which characterizes the risk of facilities. The expected loss is as the product of a default probability DP and expected recovery rate 1 — Lgd .For instance, a 3% default probability combined with an expected recovery […]
The valuation of insurance, guarantee or credit derivative depends on the correlation between the credit risk of the two parties, the risk seller/buyer of a protection and the risk buyer/seller of a protection. Whether the protection is a third-party guarantee, an insurance or results from a credit derivative does not matter in terms of valuation. […]
Support is not identical to third-party protection because it can be negative. A positive support is similar to a guarantee. The value of support depends on the joint default probability of the borrower and the supporting entity. The negative support case necessitates a specific analysis:
Since recovery uncertainty results from a number of sources of risk, modelling some of them is not sufficient to capture the overall recovery risk. For instance, we made a number of restrictive assumptions on the valuation of guarantees and support above. In such instances, it is more practical to model the overall recovery risk using […]
