Understanding Credit Risk Management in Finance

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)