This book examines best (and worst) practice in the evaluation and management of credit risk. 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.
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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
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
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.