Revised:
January 3, 2011
FIN 7400:
Financial Risk Management
III.
MANAGING NON-MARKET RISKS
A.
Credit Risk
Most of our focus until now has been on market risk, primarily the risk arising from
interest rates and exchange rates.
(Commodity prices and stock prices would also be
sources of market risk but we have not spent any significant time on these.)
But the
potential for a counterparty to a transaction to default is an important risk as well.
Credit
risk is one of the oldest risks known to mankind.
People have been lending objects and
money for about as long as humans have been around and worrying about getting paid
back.
Now that we have introduced derivative contracts, we must also recognize that
when a party enters into a derivative contract, it takes on credit risk from the possibility
that the counterparty will default.
Measuring and managing credit risk is a very
important component of an effective risk management system.
In very simple terms, credit risk is the potential for loss due to nonpayment of any
amounts owed.
The expected loss is given as follows:
Expected loss =
[probability of default] times
[amount owed] times
[percentage of amount owed not paid]
The probability of default gives the likelihood of a default event occurring.
The amount
owed is a reflection of the exposure.
The percentage not paid reflects the recovery rate.
In other words, a party might owe a certain amount but the creditor might receive some
of the amount owed.
In some cases, recovery is higher due to collateral.
Here is an example.
A bank makes a $1,000 loan to a company.
The bank believes there
is a 90% chance the company will pay back the full $1,000 and a 10% chance the
company will default.
If the company defaults, the bank expects to recover $200.
The
expected loss can be derived several ways.
The expected payback is
$1,000(0.9) + $200(0.1) = $920.
Thus, the expected loss is $80.
Alternatively, the probability of default is 0.1, the amount
owed is $1,000, and the percentage of the amount owed not paid is 80%.
Multiplying
these we obtain
$1,000(0.1)(0.8) = $80
Now let us explore the concept of the probability of default a little more.
At one time,
credit risk was understood to be simply the possibility of default.
A party might owe
$100 and have a 2% chance of default.
The expected payoff was, therefore, $98.
But
credit risk is really more complex than that.
For one, default can occur over a period of
time, not just at a point in time.
The cumulative probability of default is potentially quite
Unit IIIA Notes
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D. M. Chance, LSU