1. Introduction of Credit Risk

1. Introduction of Credit Risk

1.1 Credit Decision and Credit Analyst

1.1.1 Components of Credit Risk Evaluation

Capacity and willingness
Capacity: reputation of of a prospective borrower, and payment history or credit record of a prospective borrower.

Willingness: for most individuals, factors such as a person’s wealth, salary, or incoming cash, expenses, assets, net cash are used aas fundamental cireria.

External environment
country risk(sovereign risk), systemic risk, cyclical or secular changes

Characteristics of the relevant credit instrument
priority(e.g. senior, subordinated, unsecured)
tenor
covenants
provision / contingent / derivative risk
currency

Credit risk mitigates
Collateral: if the borrower defaults, the lender may be able to seize the collateral through foreclosure and sell it to satisfy outstanding obligations.

Secured creditor: the lender who receives collateral and complies with the applicable legal requirements.

• Lower probability of default (PD)
• Lower loss severity (LR/LGD)

Guarantees: is the promise by a third party to accept liability for the debts of another if the primary obligor defaults, and Guarantor’s creditworthiness is greater than primary obligor’s.

1.2 Introduction of Credit Risk

1.2.1 Definition

Financial Product	Credit Risk
Loan	Credit risk is the probability that a borrower failing to make full and timely payments of interest and/or principal in accordance with the terms of the credit agreement.
Bond	Credit risk reflects in credit migrations which bond issuer's creditworthiness deteriorates.
Forward	Credit risk is the risk to each party of a contract that the counterparty will not live up to its contractual obligations, which is also called counter-party risk
Swap
Option
Exotic Option

1.2.2 Three Drivers of Credit Risk

Probability of default ($\text{PD}$) is the probability that a counterparty default over a given period of time.

Exposure ($\text{EAD}$) is the amount of money lender can lose in the event of a borrower’s default.

Loss given default ($\text{LGD}$) is the amount of creditor loss in the event of a default, and it is the fraction of exposure recovered at default is recovery.

$$\text{RR}=\frac{\text{Recovery}}{\text{EAD}}=1-\frac{\text{LGD}}{\text{EAD}}=1-\text{LR}$$

Expected loss ($\text{EL}$) is the amount of a bank can expected to lose over a given period of time as a result of credit event.

$$\text{EL}=\text{EA}\times \text{PD}\times \text{LR}$$

Unexpected loss($\text{UL}$) is the worst-case loss at a given confidence level over a specific holding period, minus the expected loss, which is also called credit $\text{VaR}$.

$$\text{UL}=\text{CVaR}=\text{WCL}-\text{EL}$$