Managing Credit Risk, Vol. 1

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This book examines best (and worst) practice in the evaluation and management of credit risk. Looking at the globalisation and securitisation of credit risk it examines how credit risk is connected to market risk through trigger events. It analyses the statistical and modelling techniques which can be used to quantify and optimise credit risk management, discusses their uses, misuses, limitations and solutions. Interest areas: risk management, modelling, financial analysis, market risk, securitization, securitisation, stress testing.

"Dr Chorafas' book, based on his long experience of the subject matter, will...interest readers for the way in which it links credit and market risk issues, whilst also enlivening the text with examples from a wide range of real events."
From the Foreword by Alan Brown, Director, Group Risk, Barclays plc

Examine best and worst practice in the evaluation and management of credit risk with this authoritative text.

In two volumes, it discusses the different techniques that can be used to quantify and optimise credit risk management, evaluating their uses, limitations and solutions.

The first volume shows you how to:

• Understand the concepts of credit risk and the theory underpinning a management strategy
• Rate counterparty risk
• Explain the strengths and weaknesses of each approach.
• Integrate credit risk into the pricing of financial assets
• Use criteria, methods and tools to ensure your credit rating results are objective
• Use models in credit rating, including Standard and Poor's, Moody's and Fitch IBCA
• Understand credit volatility and market volatility and explain their impact on rating

An essential reference for senior people in the financial industry: bankers, traders, loans officers, treasurers, fund managers and other investors.

Table of Contents

Contents

Foreword
Acknowledgement
Preface

Part One: Rating the counterparty risk

Chapter 1. Counterparty risk and credit volatility
Introduction
The globalisation of counterparty risk
Credit risks, market risk and real-time risk management
Risk premium and the dynamic management of credit exposure
A changing world of counterparty risk
Product pricing and the management of counterparty risk

Chapter 2. The risk of default by counterparties
Introduction
Leveraging, default, gross and net economic loss
A sharp increase in corporate defaults and the effect of legal risk
Counterparty default risk and the value of collateral
How severe are defaults by sovereigns?
The earthquake when major debtors may be nearing default

Chapter 3. The contribution of rating agencies to the control of credit risk
Introduction
Credit risk and the challenge of outsourcing its evaluation
Contribution of rating agencies to the understanding of creditworthiness
The long-term rating system by independent agencies
Short-term rating and the concept of prime rate
Rating agencies as seen by bankers and sovereigns

Chapter 4.  A transition matrix expressing the likelihood of default
Introduction
Factual and documented answers to creditworthiness questions
Transition matrices based on the information provided by the credit score
Entropy, ergodicity, Markov chains and the use of transition matrices
Uses of and exceptions to credit transition matrices
How long does it take for a company to disappear?

Chapter 5.  Expected, unexpected and extreme events in credit risk
Introduction
A review of credit practices, credit migration and leverage
Prudence in loans commitments and their classification
The broader implications of expected, unexpected and catastrophic losses
Reconsidering the impact of position risk and default risk
Capital requirements, scoring systems and analytical tools

Chapter 6.  Credit volatility, market volatility, and their impact on rating
Introduction
Volatility ratings for market risk
Volatility ratio and change in volatility direction for credit risk
The growing importance of credit volatility in pricing financial assets
Bond defaults and credit risk volatility
Recovery rates and the case of a ratings withdrawal

Chapter 7.  Criteria for rating sovereign risk and associated challenges
Introduction
A short-list of country risk factors
Criteria applied with sovereigns rating
Country risk, politically motivated defaults and corruption
Why legal risks and transfer risks increase sovereign risk
When sovereign ratings and rating large institutions become indivisible

Chapter 8. Criteria, methods and tools to ensure objective results in credit rating
Introduction
Background and experience required of rating agency analysts
The importance of interviews and the Delphi method
A glimpse at fuzzy engineering
The role of internal controls in rating, and agency risk
The challenges of derivatives instruments and their evaluation
A case study of rating criteria used in the insurance industry
Criteria for rating municipals and sub-nationals

Chapter 9.  The use of models in credit rating
Introduction
Ratings agencies and their models - the Standard and Poor’s approach
Credit risk grading, operating characteristics curves and degrees of freedom
Tier-two collateral and the assessment of creditworthiness by the Bundesbank
Old method, new method and the able use of an expert system
The challenges of large data sets

Part Two: The challenge of analysing, pricing and replacing financial instruments

Chapter 10. Balance sheet, trading book and economic capital
Introduction
The balance sheet and the analysis of assets and liabilities
Trading book and the content of different portfolios
The banking book and non-trading transactions
Entrepreneurial and economic capital
Capital at risk and earnings at risk

Chapter 11. Limits on the counterparty
Introduction
Credit limits, present value and net present value
Dynamic management of limits and risk premiums
Comparing fair value and different intrinsic value definitions
Intrinsic value based on discounted cash flows
Measurement of performance and impairment of assets

Chapter 12. Replacement value and the counterparty’s willingness to perform
Introduction
Counterparty risk, credit equivalent loans and replacement value
Gross replacement value versus net replacement value
Notional value and replacement costs
A closer look at counterparty exposure
Reputational risk: willingness to perform versus ability to perform

Chapter 13. Integrating credit risk into the pricing of financial assets
Introduction
The need to measure and manage credit risk
The price of financial assets and marginal risk
Single transaction management
Carrying the single transaction strategy into the portfolio’s contents
Methodology for current and potential credit and market risk integration

Chapter 14. Default probabilities and their effect on the pricing of loans
Introduction
Rethinking models, transition probability and financial instruments
Bernoulli trials for default analysis
Rating, valuing and pricing securitised corporates
Pricing loans through arbitrage theory
Differences in risk taking and problems with pricing algorithms

Chapter 15. Sensitivity analysis and stress testing of different pricing hypotheses
Introduction
Modernising the use of sensitivity analysis in finance
Uncertainty, normal distribution, curvature and gamma sensitivity
The dependability of financial studies, TED and sensitivity analysis
Capital requirements and sensitivity to different risks
Stress testing and the need for more sophisticated solutions
Practical examples using stress testing
The impact of time to maturity on market risk and credit risk

Authors

Professor Dr. Dimitris N. Chorafas has, since 1961, advised financial institutions and industrial corporations on strategic planning, risk management, computer and communications systems, and internal controls. A graduate of the University of California, Los Angeles, the University of Paris, and the Technical University of Athens, Dr Chorafas has been a fulbright scholar.

Among the multinational corporations for which Dr Chorafas has worked as consultant to top management are General Electric, Bull, Univac, Honeywell, Digital Equipment Corp, Olivetti, Nestle, Omega, Italcementi, AEG-Telefunken, Olympia, Osram, Antar, Pechiney, the American Management Association and a range of other firms in Europe and the United States.

Dr Chorafas has served on the faculty of the Catholic University of America and as visiting professor at five other American universities, one Canadian, one Swiss and one German university. More that 6,000 banking, industry and government executives have participated in his seminars in the United States, England, Germany, other European countries, Asia and Latin America.

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