Chapter 12: Credit Risk
After completing this reading, you should be able to:
● Assess the credit risks of derivatives.
● Define credit valuation adjustment (CVA) and debt valuation adjustment (DVA).
● Calculate the probability of default using credit spreads.
● Describe, compare, and contrast various credit risk mitigants and their role in credit analysis.
● Describe the significance of estimating default correlation for credit portfolios and distinguish between
reduced form and structural default correlation models.
● Describe the Gaussian copula model for time to default and calculate the probability of default using the
one-factor Gaussian copula model.
● Describe how to estimate credit VaR using the Gaussian copula and the CreditMetrics approach.
1.Credit Risks of Derivatives
Credit risk is a concern in over-the-counter (OTC) derivatives transactions, where there isn’t a central counterparty to
guarantee performance. Instead, the transactions are often governed by an International Swaps and Derivatives
Association (ISDA) Master Agreement, which outlines the terms and conditions of the trades. Under this agreement,
an event of default can occur if a party fails to make payments or post margins as required or declares bankruptcy.
This can result in losses for the non-defaulting party, which are generally of two types:
● Positive Value Exposure: When the non-defaulting party has a net positive position (greater than the
collateral posted by the defaulting party), it becomes an unsecured creditor for the difference.
● Excess Collateral: When the non-defaulting party has posted collateral in excess of the value owed to the
defaulting party, it becomes an unsecured creditor for the return of this excess collateral.
2.CVA and DVA
When assessing the value of a bank’s outstanding derivatives transactions with a counterparty, three components
come into play:
● Fnd: The no-default value to the bank of the derivatives transactions.
● CVA (Credit Valuation Adjustment): The adjustment for the risk of counterparty default.
● DVA (Debit Valuation Adjustment): The adjustment for the risk of the bank’s own default.
CVA represents the present value of the expected cost to a bank of a counterparty’s default and is subtracted from
the no-default value of a derivative position. In other words, CVA is a measure of the risk of loss due to the
counterparty’s potential default. It decreases the value of the bank’s derivatives portfolio
because it represents a cost to the bank. The formula for CVA is as follows:
Where:
● qiis the risk-neutral probability of the counterparty defaulting.
● viis the exposure at the ith time interval, the present value of the expected net
exposure at the midpoint of the interval after collateral has been taken into account.
DVA, on the other hand, is the present value of expected cost to the counterparty of the bank’s default and is added
to the no-default value from the bank’s perspective. DVA, therefore, increases the value of
the counterparty’s derivatives portfolio. In other words, DVA is the cost to the counterparty
in the event of the bank’s default. Its formula is symmetrical to CVA:
Where:
Risk-neutral probability of the bank defaulting during the ith interval.
Present value of the expected loss to the counterparty (which translates into a gain for the
bank) if the bank defaults during the ith interval.
To integrate CVA and DVA into the valuation of derivatives, we calculate the adjusted value of these transactions,
incorporating the possibility of defaults. This adjustment is given by:
Where:
Fnd is the no-default value of the derivatives, which is the value assuming no default occurs. This value can be
calculated using pricing models like Black-Scholes-Merton, which do not consider credit risk.
Calculating the Probability of Default using Credit Spreads
Risk-neutral default probabilities, qi and qi* can be derived from credit spreads. For the ith interval, we can estimate
the risk-neutral default probabilities,
qi and qi*.
The following steps provide a systematic approach for calculating the probability of default using credit spreads:
● Credit Spread s(t): We start by determining the counterparty’s credit spread, s(ti) for a specific maturity through
interpolation followed by estimating the counterparty’s average hazard rate, h between time 0 and time ti:
Where s(ti) is the credit spread for maturity ti and R is the recovery rate.
● Survival Probability: Compute the probability that the counterparty survives to time,ti (not defaulting by time ti ):
● Default Probability, qi: Calculate the desired probability of default over a specific interval ( i ), between ti−1 and
ti, using the survival probabilities at the beginning and end of the interval.
The probability qi* can be calculated in a similar manner, but we consider the bank’s credit spread in this case.
Example: Computing Default Probability from Credit Spreads
Consider a corporate bond with a maturity of 2 years. Suppose the bond’s yield is 7%, the risk-free rate is 3%, and
the recovery rate is 40%. What is the probability of default occurring in the second-year interval?
Solution:
The bond’s yield is 7%, and the risk-free rate is 3%, yielding a credit spread of 4%.
We will first calculate the survival probability for the 1-year and 2-year maturities and then the probability of default
for the second year.
The probability that no default occurs by the end of the first year is:
The probability that no default occurs by the end of the second year is:
Therefore, q2, the probability of default occurring in the second year interval, is:
3.Credit Risk Mitigants and their Role in Credit Analysis
3.1Understanding Credit Risk Mitigants
Credit risk mitigants are strategies or tools used to reduce the risk that a borrower will default on its financial
obligations. Credit analysis involves evaluating the efficacy of these mitigants in protecting the lender from potential
losses. Effective mitigants lower the lender’s exposure to credit risk and can influence the terms at which credit is
extended.
3.2Netting
Netting is a method where offsetting claims with the same counterparty are consolidated into a single net claim,
thereby lowering exposure. For instance, if multiple transactions with a single counterparty result in claims of +$10
million, +$30 million, and -$25 million, rather than treating them as three separate exposures, netting would
consolidate them into one net exposure of +$15 million.
3.3Collateral Agreements
These agreements involve the provision of collateral (cash or securities) to secure a financial obligation. During
defaults in derivatives transactions, the non-defaulting party is entitled to keep any posted collateral, which can
significantly reduce credit risk. The value of marketable securities may be adjusted (“haircut”) for the purpose of
determining their cash equivalent as collateral.
3.4Downgrade Triggers
A downgrade trigger is a clause in a financial agreement that requires action if the counterparty’s credit rating falls
below a certain level. Actions may include the posting of additional collateral or the termination of outstanding
transactions at market values. However, downgrade triggers may not provide protection against sudden significant
deteriorations in credit quality and may be less effective if widely triggered throughout the market simultaneously.
4.The Significance of Estimating Default Correlation for
Credit Portfolios
4.1Importance of Default Correlation
Default correlation refers to the likelihood of simultaneous defaults within a portfolio of credit obligations. It is critical
in portfolio credit risk because it affects the distribution of losses and the potential for large, unexpected financial
setbacks.
● Diversification: Estimating default correlations helps in understanding the true diversification benefits within
a credit portfolio. Lower correlations imply higher diversification benefits, reducing portfolio risk.
● Risk Concentration: A high default correlation indicates risk concentration, suggesting that adverse
conditions affecting one obligor are likely to affect others, increasing the risk of concurrent defaults.
● Credit Derivatives Pricing: Accurate estimation of default correlations is essential for pricing credit
derivatives like collateralized debt obligations (CDOs), where tranches have different risk profiles based on
the correlation of underlying assets.
● Stress Testing and Regulatory Capital: Regulators require banks to consider default correlations in stress
testing and determining regulatory capital, ensuring institutions are sufficiently capitalized against correlated
defaults.
● Tail Risk: Default correlation is vital in assessing the tail risk of a credit portfolio, as correlated defaults can
lead to extreme outcomes or tail events.
4.2Types of Default Correlation Models
There are two main types of default correlation models:
1. Structural Models: These are based on underlying economic factors that impact a firm’s assets. The
probability of default is correlated through the dependency of assets on common factors (such as the market
or economic conditions).
2. Reduced-Form Models: These models directly specify the default correlation without linking to the assets’
value. They commonly use copulas to model dependency structures between defaults.
4.3The Gaussian Copula Model for Time to Default
The Gaussian copula model is utilized to describe the joint default likelihood across various entities or instruments.
This statistical concept hinges on the idea that the time to default of multiple entities can be correlated. The use of
copulas allows for the modeling of these dependence structures beyond just linear correlations, capturing more
complex interconnections.
In the context of credit risk, the Gaussian copula provides a way to:
● Model the probability of simultaneous defaults within a portfolio.
● Correlate default times across an array of debt instruments.
● Gauge overall portfolio risk and inform decisions on risk management and hedging strategies.
The One-Factor Gaussian Copula Model
Instead of individually defining correlations between companies i and j in our
Gaussian copula framework, it’s efficient to use a single-factor model. The core idea is:
From our original equation, this translates to
Given a specific value of F, the conditional default probability is:
In a scenario where default probabilities and inter-company
correlations are uniform (
Pi (T)=P(T) and all bi are equal), assuming the common
correlation is ρ, the equation simplifies to:
5. Credit VaR
Credit VaR, similar to market risk VaR, indicates the potential loss in credit value. For instance, a
99.9% Credit VaR over one year represents the loss level that is unlikely ( 99.9% confidence) to be exceeded in that
period.
Consider a bank with a large, homogenous loan portfolio. If defaults are equally probable across loans and
correlations between them are consistent, the Gaussian copula model can approximate the percentage of defaults
by time T as a function of F. The factor F follows a standard normal distribution, and we can be X% sure that its value
exceeds N−1(1−X). Thus, the maximum expected loss over T years in the portfolio is given by V(X,T), where:
Credit VaR can be estimated as L(1−R)V(X,T), where L is the total loan
amount and R is the recovery rate. The contribution of an individual
loan of size Li to the Credit VaR is Li(1−R)V(X,T).
6.Credit VaR under the Gaussian Copula and the
CreditMetrics Approach
Credit Value at Risk (Credit VaR) is the measure of the potential extreme loss in the value of a credit portfolio due to
adverse credit events, such as defaults, over a certain time period, given a specified confidence interval. In essence,
it is the worst-case loss one can expect under normal market conditions with a high degree of confidence.
6.1Gaussian Copula Model in Credit VaR
The Gaussian copula model’s primary strength lies in its ability to capture and represent the interdependencies
between the default times of various entities within a portfolio. This is crucial for accurately gauging the collective risk
that a portfolio faces, as it reflects the complex, intertwined nature of financial markets where the default of one entity
can significantly influence the default risk of others.
The process of calculating Credit VaR using the Gaussian copula model involves the following steps:
1. Pairwise default correlation and default probability assessment: Initially, the model necessitates the
determination of pairwise default correlations among entities, acknowledging that the financial fate of one
entity can be intertwined with that of another. Alongside this, the individual probability of default for each
entity within the portfolio needs to be established. These probabilities, often derived from credit ratings or
historical default data, serve as foundational inputs for the model.
2. Application of the copula function: Subsequently, a copula function is employed. In essence, the copula
function binds the individual default risks into a comprehensive, interconnected risk profile.
3. Simulation of default distribution and loss level identification: With the correlation structure and joint default
distribution at hand, the next step involves simulating this distribution across the entire portfolio. This
simulation unveils the various potential default scenarios, taking into account the intricate correlation patterns
among entities. Following the simulation, the model pinpoints the specific loss level corresponding to a
pre-defined confidence interval, such as 99.9%.
6.2CreditMetrics for Credit VaR
CreditMetrics, Vasicek’s model, and Credit Risk Plus are all approaches used to estimate the likelihood of losses due
to defaults. Unlike the latter two, CreditMetrics, a concept pioneered by JPMorgan in 1997, also takes into account
both downgrades and defaults. This method utilizes a rating transition matrix, drawing on either the bank’s own
historical data or external ratings, to track these changes.
When calculating a portfolio’s one-year Credit VaR, CreditMetrics employs a Monte Carlo simulation. This simulation
forecasts the credit ratings of each counterparty after one year. For those not in default at this point, the credit loss is
determined by assessing the value of all related transactions at the end of the year. For those in default, the credit
loss is the total exposure at the time of default, adjusted by the recovery rate.
The model requires the credit spread term structure for each rating category to perform these calculations. This can
either mirror the current market observations or assume a specific credit spread index with its own probability
distribution, affecting all credit spreads linearly.
Practice Question
As part of the CreditMetrics methodology for estimating credit VaR, an analyst is considering the credit migration of various debt
instruments in the portfolio over the next year. Given detailed credit transition matrices and the current market values of these
instruments, what critical steps should the analyst take to estimate the portfolio’s credit VaR?
A. Monitor the credit rating agencies for any potential downgrades and adjust the credit VaR accordingly based on expert
judgment.
B. Aggregate the individual credit VaRs of each instrument without accounting for potential migrations and diversification
effects.
C. Simulate the potential changes in credit ratings over time and determine the impact on the portfolio value to establish the
credit VaR.
D. Use the average credit spread movements to predict future creditworthiness and apply a static approach to calculate
VaR.
The correct answer is C.
With the CreditMetrics approach, the analyst utilizes credit transition matrices that capture the probabilities of migrating between
different credit ratings over a specified time frame. By simulating these migrations, the analyst can assess how potential changes
in creditworthiness are likely to affect the market value of the portfolio’s components. The aggregate impact of these changes on
the portfolio’s value facilitates the estimation of credit VaR.
A is incorrect because simply monitoring rating agencies does not constitute a methodical estimation of credit VaR based on
credit transition matrices.
B is incorrect because aggregation without considering migrations and diversification disregards key dynamics that CreditMetrics
aims to include in the credit VaR estimation process.
D is incorrect because using average spread movements for future predictions is a rudimentary approach, whereas
CreditMetrics employs a more dynamic and comprehensive simulation framework.
Things to Remember
● The CreditMetrics approach relies on the dynamic simulation of credit rating transitions to capture potential changes in
portfolio value over time.
● Credit transition matrices underpin this method by providing probabilities for various credit events, which inform the
credit VaR estimation.
● This approach acknowledges that credit risk is not static and integrates the probabilities of future rating migrations into
VaR calculations.
