Slides Week 12 - Unit revision and exam tips.pptx

19 exposure example 3 investments corporate bonds

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Exposure example 3: Investments Corporate bonds Sovereign or municipal bonds Equity Structured products e.g., asset-backed securities, money market funds 20
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Exposure example 4: Commodities Example: a power generating company enters into a long-term agreement with a buyer (“off-taker”), which commits to buy electricity at a pre-agreed price for a certain period What if the off-taker disappears/goes insolvent? Credit risk stems from the replacement cost as a new buyer would have to be found and he would pay current not historic market conditions. CURRENT ≠ HISTORIC Credit risk is NOT a fixed amount, it is dependent on the evolution of the market value of electricity over time Note that you can also be exposed to credit risk when you buy commodities on a long- term contract! 21
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Driver #2: Default Probability (PD) The credit quality of a counterparty is typically summarized by a rating: be it internal or (Provide examples) provided by rating agencies (Provide examples) Methodologies for PD calculation will be reviewed in subsequent chapters Then, historical data is used to translate a rating into a default probability What is the problem with using historical data to translate a rating into PD? Why are PDs so important in credit risk modelling? What are FICO scores? Examples of credit rating agencies in Australia? 22
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Driver #3: Recovery It is rare that a creditor loses the full amount of its credit exposure Estimating recovery is an integral part of the credit pricing Recovery expectation is a key driver of credit spread LGD = Loss Given Default = 1 – Recovery Rate LGD depends primarily on: Value of underlying assets at the time of default Seniority of claims: senior, junior/subordinated Collateral/security: unsecured, secured Recovery is very volatile from one counterparty to another S&P started assigning Recovery Ratings in 2003 23
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How is default probability computed? The probability of default is a statistical indicator that represents the likelihood that a counterparty will default during some future time period. The number is never zero, because there is always a possibility that an entity fails to generate enough revenues to honor its financial obligations. In many cases, the government could not default because they have power to raise taxes and to reduce expenses to generate the necessary funds to honor their financial commitments. However, more and more countries which relied too much on borrowed money and had be to bailed out by other countries such as Iceland. It increases with time. Most companies have a higher chance of defaulting in the long-term than in the short-term. The probability of default only defined for a given time period, such as 0.3% change of default within 2 years and 2% chance within 5 years. Hence, the probability of default will change and increase over time.
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  • Fall '19
  • Collateralized debt obligation, Credit default swap

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