12-15 FRM

FRM
12-15
Credit risk
• Credit default risk
• Credit concentration risk
• Country risk (international credit)

Credit risk Identification
Credit Risk
Securitized /
Banking book Counter party asset backed
Trading book
risk portfolio
Measurement of credit default risk
• What is Default?
• Models to help in defining the default
• Loss Estimate
• Probability of default (PD)
• Loss given a default (LGD) (EAD – Realizable value of assets)
• Exposure at Default (ED)
• Expected credit loss (ECDL)
ECDL = PD * LGD * EAD
• Retail: Application based and behavioral models

• Corporate models
Management
• Transfer (credit derivatives, insurance)
• Risk mitigation
• Create high quality assets
• Price risk
• capitalize
Identification of credit
concentration risk
Measurement of Credit concentration risk
• Concentration ratio = largest debt / total debt
• Herfindahl-Hirschman Index
Note that the pi is the share of i. pi is maximized in case of singularity and minimized when all i have equal weight
• Shannon’s Entropy
Note that pi is the probability of i. It is maximized when all values are equally likely, and minimized when only one state is possible
(concentrated).
• Gini’s coefficient = area under A / area under (A+B)
Note that a low coefficient would imply higher diversification

Gini coefficient example
• Area 1 = width (50) x height (25) x 0.5 = 625
• Area 2 = width (50) x height (25) = 1250
• Area 3 = width (50) x height (75) x 0.5 = 1875
• Area B = 625 + 1250 + 1875 = 3750

• Area A = (width (100) x height (100) x 0.5) - 3750
= 5000 – 3750 = 1250
• Gini Coefficient = (1250 / 1250 + 3750) = 0.25

Management of credit concentration risk
• Active monitoring
• Diversification
• Capitalization
Country credit risk identification
• the inability or the unwillingness
• Transfer risk
• Sovereign risk
• Non-sovereign or political risk
• Cross border risk
• Currency risk
• Macroeconomic and Structural Fragility Risk
https://rbidocs.rbi.org.in/rdocs/notification/PDFs/32084.pdf
Country credit risk measurement
• Risk Categories
https://www.oecd.org/trade/topics/export-credits/documents/cre-crc-
current-english.pdf
• Country Risk Assessments

Country credit risk management
• Fixing of country limits
• Monitoring of country exposures
Individual credit risk estimation
• Default probability estimation
• Statistical models
• Machine learning models
Default definition
• Vintage Analysis
• Roll rate analysis

Corporate Credit Risk assessment
Altman Z: The original data sample consisted of 66 firms, half of which had filed for bankruptcy under
Chapter 7. All businesses in the database were manufacturers, and small firms with assets of < $1 million
were eliminated.
The coefficients were estimated (using discriminant analysis) by identifying a set of firms which had
declared bankruptcy and then collecting a matched sample of firms which had survived, with matching by
industry and approximate size (assets).
Z = 1.2X1 + 1.4X2 + 3.3X3 + 0.6X4 + 1.0X5
X1 = ratio of working capital to total assets. Measures liquid assets in relation to the size of the company.
X2 = ratio of retained earnings to total assets. Measures profitability that reflects the company's age and
earning power.
X3 = ratio of earnings before interest and taxes to total assets. Measures operating efficiency apart from
tax and leveraging factors. It recognizes operating earnings as being important to long-term viability.
X4 = ratio of market value of equity to book value of total liabilities. Adds market dimension that can show
up security price fluctuation as a possible red flag.
X5 = ratio of sales to total assets. Standard measure for total asset turnover (varies greatly from industry
to industry).
Altman found that the ratio profile for the bankrupt group fell at −0.25 avg, and for the non-bankrupt
group at +4.48 avg.
• Zones of discrimination:
Z > 2.99 – "safe" zone
1.81 < Z < 2.99 – "grey" zone
Z < 1.81 – "distress" zone
• In its initial test, the Altman Z-score was found to be 72% accurate in predicting
bankruptcy two years before the event, with a Type II error (false negatives) of 6%
(Altman, 1968).
• subsequent tests covering three periods over the next 31 years (up until 1999),
the model was found to be approximately 80%–90% accurate in predicting
bankruptcy one year before the event, with a Type II error (classifying the firm as
bankrupt when it does not go bankrupt) of approximately 15%–20% (Altman,
2000)
• https://pages.stern.nyu.edu/~ealtman/Zscores.pdf
Z-score estimated for non-manufacturers and emerging markets
X1 = (current assets − current liabilities) / total assets

X2 = retained earnings / total assets
X3 = earnings before interest and taxes / total assets
X4 = book value of equity / total liabilities
Z-score bankruptcy model (non-manufacturers):

Z = 6.56X1 + 3.26X2 + 6.72X3 + 1.05X4[5]
Z-score bankruptcy model (emerging markets):

Z = 3.25 + 6.56X1 + 3.26X2 + 6.72X3 + 1.05X4
Zones of discrimination:
Z > 2.6 – "safe" zone
1.1 < Z < 2.6 – "grey" zone
Z < 1.1 – "distress" zone
https://pages.stern.nyu.edu/~ealtman/IRMC2014ZMODELpaper1.pdf
Z-score estimated for private firms
T1 = (Current Assets-Current Liabilities) / Total Assets

T2 = Retained Earnings / Total Assets
T3 = Earnings Before Interest and Taxes / Total Assets
T4 = Book Value of Equity / Total Liabilities
T5 = Sales/ Total Assets
Z’ Score Bankruptcy Model:

Z’ = 0.717T1 + 0.847T2 + 3.107T3 + 0.420T4 + 0.998T5
Zones of Discrimination:
Z’ > 2.9 -“Safe” Zone
1.23 < Z’ < 2. 9 -“Grey” Zone
Z’ < 1.23 -“Distress” Zone
Proprietary models
• Example: Zeta score model
• The new model, which we call ZETA®, was effective in classifying bankrupt companies up to five years
prior to failure on a sample of corporations consisting of manufacturers and retailers. Since the ZETAâ
model is a proprietary effort, I cannot fully disclose the parameters of the market.””
• We concluded that the new ZETA model for bankruptcy classification appeared to be quite accurate
for up to five years prior to failure with successful classification of well over 90% of our sample one
year prior and 70% accuracy up to five years. We also observed that the inclusion of retailing firms in
the same model as manufacturers does not seem to affect our results negatively. This is probably true
due to the adjustments to our data based on recent and anticipated financial reporting changes -
primarily the capitalization of leases
• Altman, Haldeman and Narayanan (1977)

• https://pages.stern.nyu.edu/~ealtman/Zscores.pdf
Credit risk assessment by rating agencies
Information on insolvency in India
• https://ibbi.gov.in/uploads/whatsnew/6ecf3feeaa75aaba73193cf2eb
10a954.pdf
• https://ibclaw.in/list-of-companies-resolution-plan-approved-during-t
he-jan-mar2022/
• https://insolvencyandbankruptcy.in/public-announcement/
• Research opportunity
• https://ibbi.gov.in/uploads/legalframwork/8a9654255d477bfc68365e
0562492512.pdf
Credit derivatives
• Credit default swaps

Transfer the risk: Company X wants to borrow INR 25 cr. from a bank. Company X has a
bad credit history. Bank can buy a CDS transfer the risk of default onto a third party. The
premium needs to be financed by collecting a premium from Company X. Note now the
credit quality will shift to the credit quality of the counter party instead of the borrower.
• The credit default swap index

A benchmark financial instrument made up of CDS’s. CDX (DJ) was the first CDS index,
which was created in the early 2000s and was based on a basket of single issuer CDSs. It
is of two different types : investment grade (IG) and high yield (HY). Every six months,
the underlying securities of the CDX are examined and, if appropriate, replaced with
new securities. It helps to hedge risk by protecting bond investors against default, and
traders use these indexes to speculate about potential changes in issuers’ credit quality.
• Collateralized debt obligations
Mitigate the risk: Debt are collateralized against the assets financed
(credit enhancement may be done through CDS or insurance). Note now
the credit quality will shift to the credit quality of the collateralized assets
instead of the borrower. If securitized, helps in diversifying the risk.
• Total Returns Swap

Exchange of payments based on a set rate, either fixed or variable, with
the other party who makes payments based on the return of an
underlying asset, which includes both the income it generates and any
capital gains (if any).
Structural model
What is the probability that Spot price > Strike

Price? In this case, default will occur when
Spot < Strike Price. What is the probability that
Spot < Strike Price which is give by N(-d2) in
BSM.

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FRM

• Country risk (international credit)

• Retail: Application based and behavioral models

• Gini’s coefficient = area under A / area under (A+B)

Note that a low coefficient would imply higher diversification

• Area B = 625 + 1250 + 1875 = 3750

• Gini Coefficient = (1250 / 1250 + 3750) = 0.25

• Country Risk Assessments

• Roll rate analysis

X1 = (current assets − current liabilities) / total assets

Z-score bankruptcy model (non-manufacturers):

Z-score bankruptcy model (emerging markets):

T1 = (Current Assets-Current Liabilities) / Total Assets

Z’ Score Bankruptcy Model:

• Altman, Haldeman and Narayanan (1977)

• Credit default swaps

• The credit default swap index

• Total Returns Swap

What is the probability that Spot price > Strike

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