1.4.4. Char. of the main risks of loss CR_MR an der Fachhochschule des bfi Wien

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Credit Risk - EAD (EURExposure at Default)? Ways to determine EAD?

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Credit Risk - PD (Probability of Default)?

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Credit Risk - LGD (%) (Loss given default)?

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Credit Risk - EL (Expected loss)?

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Credit Risk - Approaches?

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Credit risk - Types:

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Term to maturity

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Liquidity risk - types?

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Liquidity Premium?

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FX/CCY/Foreign exchange risk?

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FX/CCY/Foreign exchange risk-measurement?

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Liquidity risk

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1.4.4. Char. of the main risks of loss CR_MR

Credit Risk - EAD (EURExposure at Default)? Ways to determine EAD?

  • is the total value a bank is exposed to when a loan defaults
  • the predicted amount of loss a bank may be exposed to when a debtor defaults on a loan


Banks often calc. an EAD value for each loan and then use these figures to determine their overall default risk. EAD is a dynamic number that changes as a borrower repays a lender. 

EAD, along with:

  • loss given default (LGD) 
  • the probability of default (PD)

are used to calc. the bank’s credit risk capital .

1.4.4. Char. of the main risks of loss CR_MR

Credit Risk - PD (Probability of Default)?

  • the likelihood over a specified period, usually one year, that a borrower will not be able to make scheduled repayments
  • depends on the borrower's characteristics & economic environment


PD is used along with LGD & EAD in a variety of risk mng models to estimate possible losses faced by lenders

Generally, the higher the default probability, the higher the interest rate the lender will charge the borrower. 

1.4.4. Char. of the main risks of loss CR_MR

Credit Risk - LGD (%) (Loss given default)?

the amount of money a bank  loses when a borrower defaults on a loan, depicted as a % percentage of total exposure at the time of default. A bank’s total LGD is calc. after a review of all outstanding loans using cumulative losses and exposure.


LGD  = EAD - subsequent repayments

*subsequent repayments = 1 – Recovery Rate (RR)

*RR - estimated % of a loan or obligation that will still be repaid to creditors in the event of a default or bankruptcy

1.4.4. Char. of the main risks of loss CR_MR

Credit Risk - EL (Expected loss)?

EL = EAD × LGD × PD  


An important figure for any financial institution is the cumulative amount of expected losses on all outstanding loans. 


In the lending business ELs are offset as standard risk costs in order to ensure that defaults and deteriorations in creditworthiness of borrowers are covered in the credit portfolio. 


1.4.4. Char. of the main risks of loss CR_MR

Credit Risk - Approaches?

1. Standard approach: Capital adequacy is determined on the basis of:

  • the borrower segment and 
  • external ratings of actual credit portfolios 

 

The application is only done under pillar 1, as the banking supervision demands at least validated bank internal PD-estimations under pillar 2 

 

2. Internal rating based approach (IRB): PDs are calc. based on the:

  • historical default experiences a bank has made 
  • LGD recovery rate has to be estimated 


In order to calc. the capital adequacy, “through the cycle-oriented PDs” need to be used i.e. the highest default rates w/n an economic cycle are used instead of the expected value

 

3. Advanced IRB approach: 

The bank needs to estimate the recovery rate

The banking supervision requires the use of stress values instead of expected LGDs for calc. the cap. adequacy

1.4.4. Char. of the main risks of loss CR_MR

Credit risk - Types:

  1. Counterparty/default risk 
  2. Participation risk 
  3. Country risk (political, legal, transfer, performance) 
  4. Concentration risk (cluster risk) 
  5. Securitization risk 
  6. Large exposure risk 
  7. Remaining risk from credit risk mitigation techniques

1.4.4. Char. of the main risks of loss CR_MR

Term to maturity

refers to the remaining life of a debt instrument


With bonds, term to maturity is the time b/n when the bond is issued and when it matures, known as its maturity date, at which time the issuer must redeem the bond by paying the principal or face value

B/n the issue date and maturity date, the bond issuer will make coupon payments to the bondholder.

1.4.4. Char. of the main risks of loss CR_MR

Liquidity risk - types?

1) Funding (cash flow) liquidity risk 

  • if a bank have difficulties to fund its liabilities
  • tends to manifest as credit risk


2) Market (asset) liquidity (Illiquidity) risk:

  • asset illiquidity or the inability to easily exit a position
  • tends to manifest as market risk

1.4.4. Char. of the main risks of loss CR_MR

Liquidity Premium?

is a premium demanded by investors when any given security cannot be easily converted into cash for its fair market value

When the liquidity premium is high, the asset is said to be illiquid, and investors demand add. compensation for the added risk of investing their assets over a more extended period since valuations can fluctuate with market effects.

1.4.4. Char. of the main risks of loss CR_MR

FX/CCY/Foreign exchange risk?

  • refers to the losses that an international financial transaction may incur due to CCY fluctuations
  • value may decrease due to changes in the relative value of the involved CCY.

 

1.4.4. Char. of the main risks of loss CR_MR

FX/CCY/Foreign exchange risk-measurement?

Through Conditional VaR:

  • Historical simulation
  • Monte Carlo Simulation

1.4.4. Char. of the main risks of loss CR_MR

Liquidity risk

Liquidity risk stems from the lack of marketability of an investment that can't be bought or sold quickly enough to prevent or minimize a loss. It's typically reflected in unusually wide bid-ask spreads or large price movements. 


  • Liquidity is the ability to pay debts w/o  suffering catastrophic losses
  • Investors use liquidity meas. ratios when deciding the level of risk w/n an organization.
  • If an investor cannot meet its short-term debt obligations, it is experiencing liquidity risk

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