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Introduction to Credit Risk

Introduction to Credit Risk. Credit Risk vs. Market Risk Credit Risk is the risk of the other side not paying all or part according to contracted schedule When that happens the counterparty defaults How do we typically measure it?

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Introduction to Credit Risk

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  1. Introduction to Credit Risk • Credit Risk vs. Market Risk • Credit Risk is the risk of the other side not paying all or part according to contracted schedule • When that happens the counterparty defaults • How do we typically measure it? • We want to know probabilities of the event happening/what we could “expect” • How do we manage it? • Charge more • Pledged collateral • Require margin • Keep loss reserves • Hedging with derivatives (e.g., Credit Default Swaps) • Credit Risk is comes from : • Counterparties • Settlement Risk (the time it takes to get your cash or asset until it becomes “inventory”) • After the transaction settles you have an asset that needs to keep paying

  2. We now have 2 Risk Measures : Market and Credit • We will measure Credit risk using Loss Given Default • Two different measures to assess overall “Risk profile” • There are other Risk measures which we won’t cover, some less quantitative • Operational Risk • Liquidity Risk • Others (legal, reputational) Thus far we’ve focused on Market Risk only: Market Risk = “Position adjusted sensitivity” (using 1 basis point change) Price (pv): 85.731991 (that’s a total amount of $857.31 the bond is worth) DV01: 0.092519 (how much price moves with a 1/100 of 1% change in yield = .01) Amount: 10000 (10,000 is 10MM “position”) Position risk: 9.251928 That’s a $9,251 change to position value given a 1bp market move

  3. Credit Risk (...) • Our quantitative measure of Credit Risk will be “Loss Given Default” • Probability of Default “PD” • Loss Given Default “LGD” • Expected Loss “EL” • Formula EL = PD * LGD • Look up LGD’s by quality code • The parameters you need come from rating agencies which are provided • Find in SBB_ratings.h/cc (example code is ifdef’d) • The data in the source file comes from actual ratings agency download • LGD is a factor so the total LGD of the position = Amount * LGD • This is the amount we would expect lose if counterparty defaulted • A type of credit risk sensitivity: • How does my credit risk change on a ratings downgrade? • How sensitive is my bond’s value to a change in perceived credit worthiness?

  4. Submission Requirements for Mid-term Due Oct 26 • An executable which will build and run on either Linux or Mac using GNU • Deliver an archive named “yourname.tar” - create using: “tar cvf yourname.tar *” • Build by typing “make all” • Launch with shell script “run.sh” • Debug output to stderr, file descriptor 2 (see run.sh) • Encapsulate your main with “START_TIMER() and END_TIMER() • Price and calculate for each for bond position in file: • Handle either YIELD or SPREAD cases • Handle both coupon bearing and zero coupon types • Search positions in our portfolio according to below criteria: • Largest long position (write out the Amount) • Largest short position (write out the Amount) • Position with most risk (can be either long/positive or short/negative). • Total Risk for the whole portfolio (sum of individual Risks) Write out results to separate file (“results.txt”) Format of results.txt: 4 lines like: 60000 -70000 222.123 333.234

  5. Submission Requirements for Mid-term (...) • Load new trading book file : “midterm_book.txt” and yield curve file “midterm_curve.txt” • For spread priced bonds find closest maturity treasury bond • On a tie choose shorter maturity treasury • Required output format • For the individual bond results append to the end of each line read in from tradingbook.txt • “[input line] Price dv01 risk LGD” • LGD will be adjusted by amount (like Risk) • Exclude # lines (comments) • Write out the final tradingbook results into a file named “tradingbook_results.txt” • For portfolio measures write out 4 numbers (one per line) to file “results.txt” • The timer output writes out to stdout by default so: • Execute run.sh to call your executable and the only thing displayed should be the timer output. You must call run.sh to run your executable! • Units: • Show 3 decimal places for dv01 and Risk and LGD • Show 2 decimal places for price • Since units of Amount is in thousands (1000 means 1 million), Risk and LGD will be in thousands • Execution time matters! (will test by running a very large trading book)

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