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The loss distribution the loss distribution of a

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matters because it will be a function of how quickly firms are able to react to losses. The Loss Distribution The loss distribution of a credit portfolio is the relative frequency associated with all possible loss events that a portfolio could experience within a given time horizon. The Confidence Level The confidence interval is a choice variable that corresponds to a loss amount beyond which the company is not prepared to withstand. A higher confidence level goes together with a low risk appetite, and vice versa. In practice, firms with large credit portfolios set their confidence intervals to be quite high (99.5 – 99.9%), as they almost never want to face losses that can completely depleted their capital dedicated to credit.
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8. How are Loss Distributions created? 1. Probability of Default for a Single Exposure Get the data from the rating agencies If not rated, must develop own credit rating, or buy the information from vendor 2. Value of the Loss Upon Default, including Recovery of Counterparty Default Value of loss upon default including recovery is calculated by gross exposure less expected recovery Value of Loss Upon Default = Gross Exposure – Expected Recovery Expected Loss = Value of Loss Upon Default x Default Probability 3. Portfolio Effects: The Joint Default Probability Examine correlation across exposures Associated probabilities and the sum all off probabilities adds to one
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Topic 9 – Regulation & Accounting Implications of Credit Risk 1. Briefly describe the benefits of Regulation. Benefits of Regulation Alignment of Interests: The regulator, working on behalf of the customer, provides a benefit to all creditors, by keeping the regulated entity on sound footing, and to monitor, and potentially limit, its risk taking. Thus, there is an alignment of the creditors’ interests with the objective of the regulator, with the creditor getting a benefit from the regulator’s oversight and enforcement. Solvency: Regulators have strict requirements on the level of capital institutions need to hold. Riskier investment strategies require more capital, because capital is expensive, the capital rules provide an effective constraint on the level of risk taking. Oversight & Governance: A large part of oversight is disclosure, regulators require companies to disclose information about their operations, including detailed financial information. Thus, regulators provide a public good through its information gathering and dissemination. Often accompanying the information disclosure and the increased transparency is a system of early warning signs that trigger various enforcement actions, to keep the entity on sound footing. Systemic Risk & Contagion: The curtailment of risk appetite by the regulator coupled with the information disclosure requirements, creates a public good and should benefit all creditors, as systemic risk is lower in a regulated environment. Although the benefit may not be tangible to any one particular creditor, it does help to make credit markets operate more effectively.
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  • Fall '19
  • Debt, Bill Ramsey

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