Lecture 12[1] - Financial Economics for Insurance and...

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Unformatted text preview: Financial Economics for Insurance and Superannuation: Week 12 Credit Risk Models October 13, 2010 1 / 23 Summary of Lecture Credit Risk overview. Main Drivers of Credit Risk. Measuring Default Risk from Market Prices. Measuring Actuarial Default Risk. ACTL3004: Week 11 2 Credit Risk Credit risk is the risk of an economic loss from the failure of a counterparty to fulfill its contractual obiligations. Involves the possibility of nonpayment, either on a future obligation or during a transaction Its effect is measured by the cost of replacing cashflows if the other party defaults. Two forms: 1 Presettlement risk, 2 Settlement risk. ACTL3004: Week 11 3 Drivers of Credit Risk (Presettlement Risk) Credit risk measurement systems attempt to quantify the risk of losses due to counterparty default. The distribution of credit risk can be viewed as a compound process driven by these processes: 1 Default- which is a discrete state for the counterparty. This occurs with some probability of default. 2 Credit Exposure- is the economic or market value of the claim on the counterparty. It is also called Exposure at Default at the time of default. 3 Loss Given Default- represents the fractional loss due to default. ACTL3004: Week 11 4 Evolution of Credit Risk Notional Amounts Based on multiplier (8 % ). Ignores variations in the probability of default. Risk weighted amounts Categorising credit risk into risk class, providing risk weights into to multiply notional amounts. Too simplistic as there was no differentiation among credit risk classes. External/ internal credit ratings . Provide a better representation of credit risk. Internal portfolio credit models . ACTL3004: Week 11 5 Measurement of Credit Risk Default risk is the primary driver of credit risk and is represented by the probability of default. When default occurs, the actual loss is the combination of exposure at default and loss given default . Default risk can be measured using two approaches: 1 Market-price methods - credit risk can be assessed from market prices of securities whose values are affected by default eg corporate bonds, equities, credit derivatives. 2 Actuarial methods - provide “objective” measures of default rates, usually based on historical default data; Actuarial measures of default probabilities are provided by credit rating agencies, which classify borrowers by credit ratings that are supposed to quantify default risk. Such ratings are external to the firm. A credit rating is an “evaluation of credit worthiness”, an opinion of the future ability, legal obligation, and willingness of a bond issuer to make full and timely payments on dues to investors. ACTL3004: Week 11 6 Inferring Default Risk from Market Prices - Merton’s Model The Merton (1974) model views equity as akin to a call option on the assets of the firm, with the strike price given by the face value of debt....
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This note was uploaded on 08/07/2011 for the course ACTL 3004 at University of New South Wales.

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Lecture 12[1] - Financial Economics for Insurance and...

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