Charta is on Google Play: practise on the go. Get the app
Charta

State what credit risk is and illustrate, with examples, the ways it comes about.

FRM® Part II · Credit Risk Measurement and Management · Fundamentals of Credit Risk · FRM2.CR.1.a

The idea

Credit risk is the risk of loss because a counterparty fails to meet a contractual obligation in full and on time, or because its ability to do so deteriorates. It comes about in several ways. Default risk is the chance the obligor fails to pay. Exposure risk is uncertainty about how much is owed when that happens. Recovery risk is uncertainty about how much is recovered afterwards. Those three combine in the expected loss, shown here as EL = PD × EAD × LGD. Migration (downgrade) risk and credit spread risk cut market value even when no default occurs. Concentration risk arises when exposures share a borrower, sector or region. Settlement risk arises when one side delivers and the other does not. Typical sources are loans, bonds, derivatives and guarantees. The usual mistake is to equate credit risk with default alone, but losses without default are credit risk too.

Formulas

Expected credit loss

EL = PD × LGD × EAD

PD
the probability of default over the horizon
LGD
loss given default, as a share of the exposure
EAD
the exposure at default

The three elements are default, exposure and recovery risk. LGD is one minus the recovery rate; putting the recovery rate in its place is the usual slip.

A practice question

From the question bank, with the reason each wrong option is wrong.

A fund holds a corporate bond whose issuer is downgraded from A to BBB. The issuer keeps paying every coupon, but the bond price falls as its credit spread widens. Which component of credit risk caused the loss?

  1. Migration (downgrade) risk, which produces a loss in market value without a default. - correct
  2. Default risk, because the issuer has failed to meet its obligations.Why not: No default has occurred; every coupon is still being paid, so default risk has not been realised.
  3. Recovery risk, because the amount recovered on the bond has fallen.Why not: Recovery risk only matters after a default; there has been no default and no recovery process.
  4. Settlement risk, because the payment and delivery legs of the trade did not exchange.Why not: Settlement risk concerns a failed exchange of payment and delivery, which is not what happened to this bond.

A downgrade with spread widening reduces market value although the issuer pays in full. That is migration (and credit spread) risk. Default and recovery are not involved because there is no default.

A harder one

A bank holds a USD 10 million loan secured on equipment. The borrower's probability of default is unchanged, but a slump in the second-hand equipment market means the collateral would now fetch much less in a sale. Which element of credit risk has increased?

  1. Default risk, because the probability that the borrower fails has increased.Why not: The stem says the probability of default is unchanged; only what would be recovered has changed.
  2. Migration risk, because the borrower's rating has been lowered.Why not: Nothing in the stem changes the borrower's rating; the change is in collateral value, not credit quality.
  3. Exposure risk, because the amount outstanding on the loan has grown.Why not: The amount outstanding is the same; the collateral value fell, which affects the recovery rate rather than the exposure.
  4. Recovery risk, because the expected loss given default has increased. - correct

Expected loss = PD x EAD x LGD. PD and the outstanding balance are unchanged, but a lower collateral value raises LGD. That is recovery (loss severity) risk.

The hardest tier

A bank lends USD 8 million under a facility with a USD 10 million limit. The borrower's probability of default over the year is 4 percent. At default, the borrower is expected to have drawn 50 percent of the undrawn amount, and the bank expects to recover 40 percent of the exposure. The expected credit loss is closest to:

  1. USD 0.192 millionWhy not: Ignores the expected drawdown: uses the drawn amount of 8 million as the exposure instead of 9 million at default.
  2. USD 0.216 million - correct
  3. USD 0.240 millionWhy not: Assumes the full limit of 10 million is drawn at default instead of 50 percent of the undrawn 2 million.
  4. USD 0.144 millionWhy not: Uses the 40 percent recovery rate as if it were the loss rate: 0.04 x 9 x 0.4 instead of 0.04 x 9 x 0.6.

EAD = 8 + 0.5 x 2 = 9 million. LGD = 1 - 0.40 = 60 percent. Expected loss = 0.04 x 9 x 0.60 = 0.216 million. The three elements are default, exposure and recovery.

In the app: 6 practice questions on this outcome, spaced review that brings it back before you forget it.

Start free →

More in Fundamentals of Credit Risk