Managing Credit Risk

Credit risk is the potential loss in the event of default of a borrower or in the event of
deterioration in credit standing i.e. migration to a lower credit standing of a borrower, bond
issuer or counterparty in a derivative transaction

There are several possible definitions of default. Rating agencies usually consider that a default
occurs when a contractual payment is missed. The New Basel Accord includes bankruptcy and
restructuring as default events and makes it necessary to build up histories of such events as well.
Economic definition of default considers the occurrence when the value of the assets of the
borrower dips below the value of the debt. This definition differs from legal or conventional
default rules but serve for modeling default. In case of securitisation structures and funds,
defaults mean breach of covenants.

Credit Risk VaR

Credit risk VaR is central to determination of regulatory capital for credit risk and for credit risk
management. It can be defined analogously to Market Risk VaR A T-year credit VaR with an X%
confidence is the loss level that we are X% confident will not be exceeded over T years

Some credit risk VaR models consider only losses from defaults. Other models also consider
losses from downgrades or credit spread changes.

The key inputs for the calculation of credit risk VaR are:
• Probability of default or migration in rating category (estimated using transition matrices)
• Exposure at Default
• Loss given default (based on recovery data)
• Credit risk correlations

Measuring Probability of Default

Default and migration probabilities are basic inputs for capturing the risk of a facility as well as
the risk of a portfolio. The new Basel Accord considers that assigning default probabilities to
borrowers is a requirement for implementing the ‘foundation’ and ‘advanced approaches. For
determining these default and migration probabilities, there are old scoring and rating models
that use firms’ observable attributes and some new models. Rating models however do not
suffice for portfolio risk modeling because it is necessary to transform ratings into default
probabilities. Default models on the other hand directly model default probabilities that obviates
the need for mapping ratings to default probabilities.

The techniques used for modeling ratings and default probabilities include the following:
(a) Scoring and Discriminant Analysis
(b) Use of Historical Data
(c) Use of Market Data
(d) The Option Theoretic Approach
Scoring Techniques and Discriminant Analysis

Scoring techniques use discriminant analysis to separate defaulters from non-defaulters. A

famous score is Altman’s Zeta Score. It is a multivariate model built on the values of selected
ratios and categorical measures. The basic Z-Score uses five variables to discriminate between
obligors. These are (i) Working capital/Total assets (ii) Retained earnings/Total assets (iii)
EBIT/Total assets (iv) Sales/Total assets and (v) Market value of equity/Book value of liabilities.
Scoring is widely used for consumer loans as it allows automation of the credit process obviating
the need to examine the individual profile in detail. But scoring classifies borrowers only into
defaulters and non-defaulters whereas more classes are needed. The variables used in scoring are
also assumed to be independent and having constant weights.

Altman’s Z-Score

Altman‘s Z score is an example of a credit scoring tool based on data available in financial
statements. It is based on multiple discriminant analysis. The Z score is calculated as:

Z = 1.2X +1.4X +3.3X +0.6X +0.99X

1 2 3 4 5
Where

X =Working Capital/Total Assets

1
X =Retained Earnings/Total Assets
2
X =EBIT/Total Assets
3
X =Market Value of Equity/Book Value of Liabilities
4
X =Sales/Total Assets
5

If the Z > 3.0 default is unlikely; if 2.7 < Z < 3.0 we should be on alert. If 1.8 < Z < 2.7 there is
moderate chance of default; if Z < 1.8 there is a high chance of default

Use of Historical Data

Data on defaults, migrations and recoveries are available from historical records or from rating
agencies. Internal bank data warehouse might have detailed credit risk data by borrower and
transaction. Banks map their internal ratings to external default frequencies using an intermediate
mapping between their own ratings and those of external ratings. Calculation of default rates
involves the following steps:

- Aggregating default data for a given cohort of firms, defined by those firms surviving
and rated at the beginning of a given year.

- Breaking down the cohort into sub-portfolios by rating

- Calculating the default rate as the ratio of the number of defaults in a given period over
the total of surviving firms at the beginning of the period .

Thus yearly default rates are ratios of defaulted firms to surviving firms at the beginning of the
year. These can be arithmetic default rates or value weighted default rates.

Cumulative Average Default Rates (%) (1970-2010, Moody’s)

Time (years)

1 2 3 4 5 7 10

Aaa 0.000 0.013 0.013 0.037 0.104 0.244 0.494

Aa 0.021 0.059 0.103 0.184 0.273 0.443 0.619
A 0.055 0.177 0.362 0.549 0.756 1.239 2.136
Baa 0.181 0.510 0.933 1.427 1.953 3.031 4.904
Ba 1.157 3.191 5.596 8.146 10.453 14.440 20.101
B 4.465 10.432 16.344 21.510 26.173 34.721 44.573
Caa 18.163 30.204 39.709 47.317 53.768 61.181 72.384

From the yearly default rates, default rates of a rating class and its volatility over time are
derived. The default rates are close to zero for the best risk qualities. They increase to around
18.16% a year for the lowest risk class (in Moody’s simplified rating scale). The top three rating
classes characterize investment grade borrowers. The others are speculative grade.

Cumulative Default Probability

The cumulative default probability is the probability that a borrower will default over a multi-
year period.

C = 1-(p x p x …… x p )
p 1 2 n

Where C is the cumulative default probability, p is the marginal probability of no default for
p n
year n.

In the first year, the cumulative and marginal default probabilities are equal.

If the marginal probabilities of default for year 1 and year 2 are 0.06 and 0.08, respectively, the
cumulative probability that the default will occur over a two year period is:
1-(0.94 x 0.92) = 13.52%
 • The cumulative default probability is the probability that a borrower will default over a
multi-year period.
• C = 1-(p x p x …… x p )
p 1 2 n

Where C is the cumulative default probability, p is the

p n
marginal probability of no default for year n.
• In the first year, the cumulative and marginal default probabilities are equal.
• If the marginal probabilities of default for year 1 and year 2 are 0.06 and 0.08,
respectively, the cumulative probability that the default will occur over a two year period
is:
1-(0.94 x 0.92)= 13.52%

Unconditional and Conditional Default Probabilities

The unconditional default probability is the probability of default for a certain time period as
seen at time zero The conditional default probability is the probability of default for a certain
time period conditional on no earlier default The probability of a bond rated Caa or below
defaulting during the third year (unconditional default probability) is 9.505% (39.709%-
30.204%). The probability that it will default during the third year conditional on no earlier
default is 13.62% (0.09505/.69796)

Hazard Rate

The conditional default probability for a short time period of length ∆t is called the Hazard Rate
or Default Intensity and is denoted by ʎ(t). The probability of default by time t, Q(t) is related to
the average hazard rate  between time zero and time t in the following manner.

Q(t )  1  e  (t )t

If the hazard rate is constant 1.5% per year, the probability of a default by the end of year 1 is 1-
-0.015x1 -0.015x2
e = 0.0149. The probability of default by the end of year 2 is 1-e = 0.0296 . The
unconditional probability of default in year 2 is 0.0147 (0.0296-0.0149). The probability of
default in year 2 conditional on no earlier default is 0.0147/(1-0.0149)=0.0149

Default Probability from Market Data

Risk premiums inherent in the current structure of yields on corporate debt or loans to similar
risk related borrowers are used to derive the expected default probabilities. For example, if the
risk free return for one year is 10% and the expected return from a corporate bond of grade B is
15.8%, the probability of repayment perceived by the market is 1.10/1.158 or 0.95. The
probability of default is 5% and the risk premium for a default probability of 5% is 5.8%.

Estimating Default Probabilities from Bond Spreads


 s
Average default intensity   over life of bond is approximately
1 R
where s is the spread of the bond’s yield over the risk-free rate and R is the recovery rate

Example
The 3-year credit spread is 50 basis points and the 5-year credit spread is 60 basis points. The
expected recovery rate is 60%
Average hazard rate over 3 years =0.005/(1-0.6) = 0.0125
Average hazard rate over 5 years = 0.006/(1-0.6) = 0.015
Average hazard rate between year 3 and year 5
(5 x 0.015-3 x 0.0125)/2 = 0.01875
Example

A one-year T-bill yields 2% while a one-year corporate bond yields 3%. Assuming that no
recovery is possible in case of a default, the probability of default is 0.97% as shown below:

Let us assume that we invest Rs.1 for one year either in a T-bill or a risky investment. If the
probability of default is PD, the following equation must hold good.

1.02 = 1.03 (1-PD) + 1.03 (PD) (RR) where RR is the recovery rate.

PD = 1-1.02/1.03 =0.0097 or 0.97%

If the recovery rate is 50%, then the estimate of the probability of default is 1.94% as shown
below:

1.02 = 1.03 (1-PD) + 1.03 (PD) (0.5)

0.515 PD = 0.01 or PD = 0.0194

Estimating Default Probabilities from Bond Prices

Assume that a five year corporate bond pays a coupon of 6% per annum (semiannually). The
yield is 7% with continuous compounding and the yield on a similar risk-free bond is 5% (with
continuous compounding). Price of risk-free bond is 104.09; price of corporate bond is 95.34;
expected loss from defaults is 8.75. Suppose that the probability of default is Q per year and that
defaults always happen half way through a year (immediately before a coupon payment). The
recovery rate is 40%
We set 288.48Q = 8.75 to get Q = 3.03%

This analysis can be extended to allow defaults to take place more frequently. With several
bonds we can use more parameters to describe the default probability distribution

Option Theoretic Approach

The Option Theoretic Approach to default considers that the equity holders have a call option on
the value of the firm’s assets, whose strike price is the debt. If the asset value falls below the
value of debt, the equity holders are better off by giving the assets to the lenders rather than
repaying the debt. The gap between the expected asset value and the threshold value of debt
triggering default is termed as ‘Distance to Default’. The distance to default varies inversely with
the default probability. The output of this approach is “Expected Default Frequency (EDF)”

Merton (1974) proposed a model where a company’s equity is an option on the assets of the
company. We define:
V : Value of company’s assets today
0

V : Value of company’s assets at time T

T

E : Value of company’s equity today

0

E: Value of company’s equity at time T

T

D: Amount of debt interest and principal due to be repaid at time T

 : Volatility of assets (assumed constant)
V
  : Instantaneous volatility of equity
E

If V <D, it is rational for the company to default on the debt at time T. The value of the equity is
T
then zero. If V >D, the company should make the debt repayment at time T and the value of the
T
equity at time T is V -D. Merton’s model, therefore, gives the value of the firm’s equity at time
T
T as
E = max(V -D,0)
T T

The Black-Scholes formula gives the value of the equity today as:

E0  V0 N (d1 )  De  rT N (d 2 )
ln V0 / D  (r   V2 / 2)T
Where d1  and d 2  d1   V T (1)
V T
N is the cumulative normal distribution function

The value of debt today is V -E

0 0
The risk-neutral probability that the company will default on the debt is N(-d ). To calculate
2
this, we require V and  Neither of these is directly observable. However, if the company is
0 V.
publicly traded, we can observe E
0

It can be shown that  E   E , A  V where  E , A denotes the elasticity of equity to asset value, i.e.
 E , A  (V0 / E0 )(E / V )
In the simple Merton’s framework, where the firm is financed only by equity and a zero coupon
debt, equity is a call option on the assets of the firm with strike price equal to the face value of
the debt and maturity equal to the redemption date of the bond. Then, the partial derivative
E / V is simply the delta of the call with respect to the underlying asset of the firm.

Therefore:  E  (V0 / E0 )(E / V ) V

E
 E E0   V V0
V
 E E0  N (d1 )VV0 (2)

Equations (1) and (2 ) provide a pair of simultaneous equations that can be solved for V and  .
0 V

Migration Probabilities
The migration probabilities are based on historical data. A migration to any state other than the
default state does not trigger any loss in the book value, but the default probability changes.
Change in the default probability causes change in the mark-to-market value because of a change
in the discount rate that depends on the credit spreads.

When time drifts, the risk either improves or deteriorates. For example if the rating of a company
is B+ on 31.03.2003 and B as on 31.03.2004, it represents a deterioration of risk These shifts are
captured by the transition frequencies between risk classes. Within a given period, transition
rates between classes are transfer frequencies divided by the number of original firms in each
class. The transition matrix looks like the table given below. Each row and each column is a
rating class. All probabilities sum to 1 across rows. The last column shows withdrawn ratings.

The transition matrix looks like the table given below. Each row and each column is a rating
class. All probabilities sum to 1 across rows. The last column shows withdrawn ratings. Rating
agencies publish several matrices typically 1 year, 2 years and 5 years.

One-year Rating Transition Matrix (% Probability) Moody’s 1970-2010

Initial Rating at year end
Rating Aaa Aa A Baa Ba B Caa Ca-C Default
Aaa 90.42 8.92 0.62 0.01 0.03 0.00 0.00 0.00 0.00

Aa 1.02 90.12 8.38 0.38 0.05 0.02 0.00 0.02

A 0.06 2.82 5.52 0.11 0.03 0.06
Baa 0.19 4.79 89.41 4.35 0.82 0.18 0.02 0.19
Ba 0.01 0.06 0.41 6.22 83.43 7.97 0.59 0.09 1.22
B 0.01 0.14 0.38 5.32 82.19 6.45 0.74 4.73
Caa 0.00 0.02 0.16 0.53 68.43 4.67 16.76
Ca-C 0.00 0.00 0.00 0.00 0.39 2.85 10.66 43.54 42.56
Default 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 100.00

Illustration

Calculate the probability of a Baa rated entity defaulting over a 2-year period from the following
one-year transition matrix

Rating from Rating to

Aaa Baa Caa Default
Aaa 91.75% 0.17% 0.00% 0.00%
Baa 0.05% 87.50% 0.18% 0.31%
Caa 0.00% 0.25% 75.24% 15.69%

Probability of Baa –rated entity defaulting in year 1 =0.31%

Probability of Baa-rated entity migrating to Aaa rating in one year =0.05%
Probability of Baa-rated entity migrating to Caa rating in one year =0.18%
Probability of Aaa-rated entity defaulting in year2 =0.05% x 0.00% =0.00
Probability of Caa-rated entity defaulting in year 2 =0.18% x 0.31% =0.0006%
Probability of Baa-rated entity defaulting in two years =0.31% +0.0006% =0.3106%

Exposure at Default
Exposures are future amounts at risk. These are either at book value or at mark-to-model values.
Valuation of losses under book value ignores migration risk and results in loss under default
only. It is desirable to capture changes in credit standing which do not materialize in the book
value but alter the default probability of the borrower. Marking to model exposures serve for
valuing migrations by discounting future flows from assets at a discount rate adding the credit
risk spread to the risk free rate. Credit risk models capturing migrations are full valuation
models. Those using book values are default models.

For banking credit exposures the relevant distinctions are ‘On-balance sheet’ versus ‘Off-balance
sheet’. For On-balance sheet items, exposure differs from current usage because the amount at
risk at future dates is uncertain. In case of term loans, though the amortization profile is known,
prepayments can take place. Overdrafts, consumer loans and credit card balances are subject to
renewal and borrowers can make new drawings at their initiative. Rollover lines generate a long-
term exposure beyond the roll over dates. Committed lines of credit are on-balance sheet for the
used portion and off-balance sheet for the unused portion. Project financing is subject to
exposure uncertainty both for the construction phase and for the subsequent operation phase
when repayments occur. In all the above cases, it is necessary to define what are expected
exposures at future horizons and the exposure under default that might increase when credit risk
deteriorates. The New Basel Accord stipulates that Exposure at Default (EAD) is a key input to
the risk assessment process.

For Off-balance sheet items, it is never certain whether these will move up to being on-balance
sheet. For committed lines of credit, the economic exposure is 100% of the commitment even if
there is no current usage. For derivatives, the risk is the potential positive liquidation value of
instruments until maturity. Loan equivalents of derivatives are computed for arriving at the risk
exposure.

Credit exposure can be broken down into two components – current exposure and potential exposure.
Current exposure is the exposure which exists today.
Potential exposure is the likely exposure in case the credit deteriorates.
Adjusted exposure takes into account both current and potential exposure.

Adjusted Exposure

Adjusted Exposure = Outstanding + (commitment- outstanding) x drawdown on default

A commitment represents the total amount the bank is prepared to lend to the borrower. On the other
hand, outstandings refers to the actual amount loaned. Thus the commitment consists of two
components – the outstanding and the unused portion of the commitment. The undrawn portion is
nothing but a borrower‘s call option to draw on the full credit line in distress. During distress, the
borrower will indeed draw on the remaining amount, fully or partly. The Adjusted exposure is
nothing but the prior exposure adjusted for this drawdown.

Illustration

A loan of Rs.3,000,000 granted by a bank has an 80% outstanding. The drawdown on default is
estimated at 60%. The adjusted exposure is Rs.2,760,000, calculated as follows:

Adjusted Exposure = Outstanding + (commitment- outstanding) x drawdown on default

= 3,000,000 x 0.8 +(3,000,000-2,400,000) x 0.6 = Rs.2,760,000

Loss given Default

The loss in the event of default is the amount at risk at default time less recoveries. The New
Basel Accord recognizes that some guarantees deserve recognition in assessing losses. The main
guarantees are:

- Collaterals which are assets seized by the lender if the borrower defaults

- third party protections such as guarantees, insurance and credit derivatives

- covenants which are contractual clauses such as maximum debt cover ratio or a
legal obligation not to diversify away from the core business.

Recovery data is taken from historical experience. The recovery rates vary widely from one
transaction to another and from one type of guarantee to another. Modeling of recoveries is
important because:

(a) A distinctive feature of the foundation approach consists of assigning recovery rates to
facilities and alleviating capital charge accordingly, which provides a strong incentive for
quantification.

(b) Certain guarantees are tangible enough to deserve recognition and valuation.

(c) The loss given default or exposure minus recoveries is a critical input for assessing credit
risk.

(d) The expected loss is the product of loss given default with default probabilities. It is the basis
of economic provisioning.

(e) Recovery rates allow us to define ratings by mapping expected loss percentages to ratings.

A beta distribution is generally used to model recoveries. The beta distribution has the attractive
property of being representative of any shape of recovery distribution. These can be U-shaped,
representative of the fact that either we recover something or not. They can also be bell shaped or
highly skewed. For example in some cases there is no reason why recovery should be significant
like with unsecured transactions. The mode gets close to zero. Nevertheless, due to uncertainties,
we still might recover more than that.

Recoveries are a major determinant of loss under default. Recovery data by seniority level, type
of product and nature of guarantee can help differentiate recoveries for these sub-classes.
Moody’s has provided the following data for recovery rates based on seniority level of debt:

The recovery rate for a bond is usually defined as the price of the bond immediately after default
as a percent of its face value. Recovery rates tend to decrease as default rates increase

Recovery Rates On Corporate Bonds As a Percentage of Face Value (1982-2003)

Class Average Recovery

Rate (%)
Senior Secured 51.6
Senior Unsecured 36.1
Senior Subordinated 32.5
Subordinated 31.1
Junior Subordinated 24.5

Source: Moody’s

According to Moody’s, the recovery rates are correlated with economic conditions. When they
worsen, the recoveries also do.

Expected and Unexpected Loss

Expected loss is the average loss in value over a period of time for a given exposure. The expected
loss is best handled by building it into the product price.

Expected loss = Adjusted Exposure x Loss Given Default x Probability of Default

The unexpected loss refers to the variability of potential loan loss around the average loss level. The
unexpected loss can be viewed as some multiple of the standard deviation of the expected loss. The
essence of credit risk management is arriving at a good estimate of the unexpected loss

Unexpected loss (UL) is a quantile of the credit loss in excess of the expected loss. It is
sometimes defined as the standard deviation, and sometimes as the 99th or 99.9th percentile of
the loss in excess of the expected loss. The standard definition of credit Value-at-Risk is cast in
terms of UL:

It is the worst case loss on a portfolio with a specific confidence level over a specific holding
period, minus the expected loss. This is quite different from the standard definition of VaR for
market risk. The market risk VaR is defined in terms of P&L. It therefore compares a future
value with a current value. The credit risk VaR is defined in terms of differences from EL. It
therefore compares two future values.

Credit Risk Correlations

A key aspect of any credit risk VaR model is credit correlation. Defaults (or downgrades or credit
spread changes) for different companies do not happen independently of each other. During an
economic downturn, most companies are adversely affected and become more likely to default
while they are less likely to default when the economy is faring well. The relationship between
default rates and economic factors is what determines credit correlation.

Credit risk correlations serve to determine the risk of portfolio of loans. Correlations reflect the
extent to which loans tend to default simultaneously. This may happen because the correlation
building blocks of credit risk models capture the obligors’ credit risk correlation across
borrowers and/or with external factors. This is a critical modeling block because:

The correlations of credit risk are positive increasing the risk of losses. They drive the shape of
loss distributions and generate fat tails highly sensitive to correlations.They relate to external
conditions and economic cycles.

To model correlations, the common principle for all portfolio models is to relate individual risks
of each transaction to a set of common factors. The intuition is that such factors as the state of
economy drive the default probabilities. They also affect migration probabilities since all firms
tend to migrate to worse credit states when conditions deteriorate.

KMV uses the option approach to find the joint probability that the correlated values of the assets
of two firms hit the threshold value of debts. Credit Metrics uses joint migration matrices
providing the joint transition probability of migrating to various credit states for pairs of
obligors. CPV derives default correlations from their common dependence on economic factors.
Credit Risk+ offers the possibility of making default intensities of mixed Poisson distribution of
each portfolio segment dependent on common factors. The correlation between risk drivers result
from the coefficient of factor models and the specific credit risk from the error term that captures
the risk unrelated to common factors.

Credit Risk Models

Vasicek’s Model
The Basel II internal-ratings-based (IRB) capital requirements for credit risk in the banking book
are based on Vasicek’s Gaussian copula model. This is a way of calculating high percentiles of
the distribution of the default rate for a portfolio of loans. The model relates WCDR (T,X) to the
probability of default, PD, and a parameter, ρ, describing credit correlation. WCDR is the worst
case default rate and WCDR (T,X) is the Xth percentile of the default rate distribution during a
period of length T
For a large portfolio of loans, each of which has a probability of PD of defaulting by time T the
default rate that will not be exceeded at the X% confidence level is

 N 1 ( PD)   N 1 ( X ) 
WCDR(T , X )  N  
 1 
 
Where r is the Gaussian copula correlation

For an individual loan , if EAD is the exposure at default and LGD is the loss given default
VaR(T,X) = EAD x LGD x WCDR (T,X)

If we have a portfolio of loans where each loan has the same probability of default, Vasicek’s
result can be used to calculate the value at risk for a confidence level of X and a time horizon T
as:
n
VaR(T , X )   EADi  LGDi  WCDRi (T , X )
i 1

Illustration

Suppose that a bank has a total of Rs.100 million of retail exposures of varying sizes with each
exposure being small in relation to the total exposure. The one-year probability of default for
each loan is 2% and the loss given default for each loan is 40%. The copula correlation
parameter, ρ, is estimated as 0.1.
 N 1 (0.02)  0.1N 1 (0.999) 
WCDR(1, 0.999)  N  
 1  0.1 
-1 -1
Given that N (0.02) = -2.05375, N (0.999)=3.090232,
WCDR = N(-1.1348) = 0.128 or 12.8%
Losses when the WCDR occurs is Rs.100 x 0.4 x0.128 = Rs. 5.13 million.

This is an estimate of the value at risk with a one-year time horizon and a 99.9% confidence
level.

Credit Risk + Model

Credit Risk + methodology was proposed by Credit Suisse Financial Products in 1997.
CreditRisk+ applies an actuarial science framework to the derivation of the loss distribution of a
bond/loan portfolio. Only default risk is modeled, not downgrade risk. The default risk is not
related to the capital structure of the firm.

The distribution of default losses for a portfolio is derived in two stages, as shown in the
following Figure
Frequency of default events is estimated using the Poisson process. In CreditRisk+ the exposure
for each obligor is adjusted by the anticipated recovery rate, in order to calculate the loss given
default. These adjusted exposures are exogenous to the model, and are independent of market
risk and downgrade risk. The required VaR is calculated from the distribution of default losses.

Credit Metrics Model

Credit Metrics methodology is based on the estimation of the forward distribution of the changes
in value of a portfolio of loan and bond type products at a given time horizon, usually 1 year. The
changes in value are related to the eventual migrations in credit quality of the obligor, both up
and downgrades, as well as default.

Credit Metrics risk measurement framework has two main building blocks, i.e. ``value-at-risk
due to credit'' for a single financial instrument, then value-at-risk at the portfolio level which
accounts for portfolio diversification effects (``Portfolio Value-at-Risk due to Credit''). There are
also two supporting functions, ``correlations'' which derives the asset return correlations which
are used to generate the joint migration probabilities, and ``exposures'' which produces the future
exposures of derivative securities, like swaps.
The first step is to specify a rating system, with rating categories, together with the probabilities
of migrating from one credit quality to another over the credit risk horizon. This transition matrix
is the key component of the credit-VaR model proposed by JP Morgan. It can be Moody’s, or
Standard & Poor’s, or the proprietary rating system internal to the bank. A strong assumption
made by Credit Metrics is that all issuers are credit-homogeneous within the same rating class,
with the same transition probabilities and the same default probability.

Second, the risk horizon should be specified. It is usually 1 year, although multiple horizons
could be chosen, like 1to10 years, when one is concerned by the risk profile over a longer period
of time as it is needed for long dated illiquid instruments. The third phase consists of specifying
the forward discount curve at the risk horizon(s) for each credit category, and, in the case of
default, the value of the instrument which is usually set at a percentage, named the ``recovery
rate'', of face value or ``par''. In the final step, this information is translated into the forward
distribution of the changes in portfolio value consecutive to credit migration

Calculation of Credit-VaR for a senior unsecured BBB rated bond maturing exactly in 5
years, paying an annual coupon of 6%.

Step 1: Specify the transition matrix. The probability of a BBB rated bond migrating to different
rating categories within one year is given by the transition matrix.
Step 2: Specify the credit risk horizon. The risk horizon is usually 1 year, and is consistent with
the transition matrix .

Step 3: Specify the forward pricing model. The valuation of a bond is derived from the zero-
curve corresponding to the rating of the issuer. Since there are 7 possible credit qualities, 7
``spread'' curves are required to price the bond in all possible states, all obligors within the same
rating class being marked-to-market with the same curve. The spot zero curve is used to
determine the current spot value of the bond.

The forward price of the bond in 1 year from now is derived from the forward zero-curve, 1 year
ahead, which is then applied to the residual cash flows from year one to the maturity of the bond.

One-year forward zero-curves for BBB credit rating (%)

Year 1 Year 2 Year 3 Year 4
BBB 4.10 4.67 5.25 5.63

The 1-year forward price of the bond, if the obligor stays BBB, is

6 6 6 106
VBBB•  6      107.55
2 3
1.0410 (1.0467) (1.0525) (1.0563) 4
If we replicate the same calculations for each rating category we obtain the following values.

Year-end rating Value

AAA 109.37
AA 109.19
A 108.66
BBB 107.55
BB 102.02
B 98.10
CCC 83.64
Default 51.13

If the issuer defaults at the end of the year, the applicable recovery rate is applied (51.13% in the
present case)

• Step 4: Derive the forward distribution of the changes in portfolio value.

 Year-end Probability of Forward Change in value
rating state : p(%) price
AAA 0.02 109.37 1.82
AA 0.33 109.19 1.64
A 5.95 108.66 1.11
BBB 86.93 107.55 0
BB 5.30 102.02 -5.53
B 1.17 98.10 -9.45
CCC 0.12 83.64 -23.91
Default 0.18 51.13 -56.42

The distribution of the changes in the bond value, at the 1-year horizon, due to an eventual
change in credit quality exhibits long downside tails. The first percentile of the distribution of
∆V, which corresponds to credit-VaR at the 99% confidence level is 23.91.

KMV Model

Unlike Credit Metrics, KMV does not use Moody’s or Standard & Poor’s statistical data to
assign a probability of default which only depends on the rating of the obligor. Instead, KMV
derives the actual probability of default, the Expected Default Frequency (EDF), for each obligor
based on a Merton (1974)’s type model of the firm. The probability of default is thus a function
of the firm’s capital structure, the volatility of the asset returns and the current asset value. The
EDF is firm-specific, and can be mapped into any rating system to derive the equivalent rating of
the obligor.

KMV best applies to publicly traded companies for which the value of equity is market
determined. The information contained in the firm’s stock price and balance sheet can then be
translated into an implied risk of default. The derivation of the probabilities of default proceeds
in 3 stages.
1. Estimation of the market value and volatility of the firm’s assets
2. Calculation of the distance-to-default, which is an index measure of default risk
3. Scaling of the distance-to-default (DD)to actual probabilities of default using a default
database.

DD is the number of standard deviations between the mean of the distribution of the asset value,
and a critical threshold, the ``default point'', set at the par value of current liabilities including
short term debt to be serviced over the time horizon, plus half the long-term debt

• Formally DD is defined as follows:

STD short-term debt,
 LTD long-term debt,
DPT default point=STD+ 1/2LTD,
DD distance-to-default which is the distance between the expected asset value
in 1 year, E(V ) and the default point, DPT expressed in standard
1
deviation of future asset returns

E (V1 )  DPT
DD 
A
This last phase consists of mapping the DD to the actual probabilities of default, for a given time
horizon. These probabilities are called by KMV, EDFs, for Expected Default Frequencies. Based
on historical information on a large sample of firms, which includes firms which defaulted one
can estimate, for each time horizon, the proportion of firms of a given ranking, say DD=4, which
actually defaulted after 1 year. This proportion, say 40 bp, or 0.4%, is the EDF

Current market value of assets V0 1000

Net expected growth of assets per annum 20%
Expected asset value in 1 year V0 (1.20) 1200
Annualized asset volatility, σ 100
Default point 800
Then DD = (1200-800)/100 4

Assume that among the population of all the firms with a DD of 4 at one point in time, say 5000
firms, 20 defaulted 1 year later, then:

EDF1 yr =20/5000 =. 0.004 = 0.4% or 40 bp. The implied rating for this probability of default is
+
BB .

Credit Portfolio View Model

Credit Portfolio View is a multi-factor model which is used to simulate the joint conditional
distribution of default and migration probabilities for various rating groups in different
industries, for each country, conditional on the value of macroeconomic factors like the
unemployment rate, the rate of growth in GDP, the level of long-term interest rates, foreign
exchange rates, government expenditures and the aggregate savings rate.

Credit Portfolio View is based on the casual observation that default probabilities, as well as
migration probabilities, are linked to the economy. When the economy worsens both downgrades
as well as defaults increase. It is the contrary when the economy becomes stronger.

Provided that data is available this methodology can be applied in each country, to different
sectors and various classes of obligors which react differently over the business cycle like
construction, financial institutions, agriculture, services, etc.
Standalone Credit Risk:

The standalone risk concerns a facility and not a portfolio of loans. It can be modeled under a
simple default mode valuation (which considers only two possible states, default or no-default)
or under a full valuation which incorporates migrations to various states over a time horizon.
Under the default mode valuation, the inputs used are the default
probability (d), the loss given default (Lgd) and the loss volatility. The expected loss is given by
(d)(Lgd) and the loss volatility by Lgd d (1  d ) .

Under full valuation mode, there are as many values as there are migration states plus the default
state. A single facility has a distribution of values at a preset horizon, one for each migration
including one for the default state. Expected loss, loss volatility and loss percentile are derived
from this loss distribution. KMV portfolio manager models migrations through asset value
changes while others rely on migration matrices provided by rating agencies.

If Lgd =40% d= 5%, the expected value of exposure E(v) = 1-(.4*.05) = 0.98 or 98%.

The expected loss(%) is given by (d)(Lgd) i.e. .4*.05 = .02 or 2%

The loss volatility is the square root of (d)(1-d) multiplied by Lgd i.e. 8.72%
The above formulae apply to a single standalone banking exposure when there are only two
possible states, default or no default.

Cumulating risk over several periods changes the binary distribution of a single exposure into a
loss distribution with more than two values depending upon the migration states. A single facility
has a distribution of values at a preset horizon, one for each migration including the default state.
Expected loss, loss volatility and loss percentiles are derived from this loss distribution.

Example:

Facility Bullet loan of Rs.1,000 maturity 2 years

Coupon 5.30% , Rating B
Cash Flows Rs. 30 at end year 1 Rs. 1,053 end year 2
Risk Free Rate 5%, credit spread for risk 30 basis points

Migration Matrix
Current Transition Final Rating Yield with Value At Gain (+)
Class Probability Class End Credit End of year Loss (- )
Year 1 Spread 1 of Rs.1053

Date 0 10.00% A 5.10% 1001.903 1.903

B 82.00% B 5.30% 1000.000 0
7.00% C 5.80% 995.274 -4.726
0.50% D 6.50% 998.732 -11.268
 0.00% E 8.00% 975.000 -25.000
0.50% Default 0 -1000.000
---------
100.00%

Mean: Rs. 994.803

Volatility: Rs. 70.538

The value distribution at end of year 1 exhibits skewness and a larger downside tail than the
upside tail. The loss percentile at 99% is –4.726 from the above table. The loss distribution is
highly skewed to the left (losses are on left hand side)

Portfolio Credit Risk

The process of measuring credit risk for a portfolio of credit assets is different from that of a
standalone asset because of correlations that come into play for a portfolio

Credit risk correlations serve to determine the risk of portfolio of loans. Correlations reflect the
extent to which loans tend to default simultaneously. This may happen becauseThe correlation
building blocks of credit risk models capture the obligors’ credit risk correlation across
borrowers and/or with external factors. This is a critical modeling block because:

The correlations of credit risk are positive increasing the risk of losses.
They drive the shape of loss distributions and generate fat tails highly sensitive to correlations
They relate to external conditions and economic cycles.

To model correlations, the common principle for all portfolio models is to relate
individual risks of each transaction to a set of common factors. The intuition is that such
factors as the state of economy drive the default probabilities. They also affect migration
probabilities since all firms tend to migrate to worse credit states when conditions
deteriorate.

KMV uses the option approach to find the joint probability that the correlated values of the assets
of two firms hit the threshold value of debts. Credit Metrics uses joint migration matrices
providing the joint transition probability of migrating to various credit states for pairs of
obligors. CPV derives default correlations from their common dependence on economic factors.
Credit Risk+ offers the possibility of making default intensities of mixed Poisson distribution of
each portfolio segment dependent on common factors. The correlation between risk drivers result
from the coefficient of factor models and the specific credit risk from the error term that captures
the risk unrelated to common factors.

Modeling Portfolio Loss Distributions:

Most vendor models generate correlated loss distributions using Monte Carlo simulations. KMV
Portfolio Manager uses Monte Carlo simulations of modeled asset values of obligors. Credit
Metrics uses both Monte Carlo simulations and joint migration matrix technique. Credit Portfolio
View (CPV) uses Monte Carlo simulation of economic factors. Credit Risk+ is a notable
exception with its analytical loss distribution. It makes
use of convenient numerical formulae to determine loss statistics and loss percentiles bypassing
the calculation intensive simulation process.

The principle of simulations is to generate correlated random credit risk drivers complying with a
given variance-covariance structure. The risk drivers are asset values or economic variables. To
generate correlated returns with a preset variance-covariance structure, Cholesky decomposition
is a popular technique. Factor models serve both to measure correlations and generate correlated
factor values by varying the factors on which risk drivers depend. In this case Cholesky
decomposition serves to generate correlated factor values converted into risk driver values and
finally into correlated default or migration events.

Let the portfolio data be as follows:

Customer Default Probability Exposure (Rs.lakh)

A 7% 100
B 5% 50
Correlation 10%

Calculation of Conditional and Joint Probabilities:

A B Conditional Prob. Joint Prob.

Default 7% Default 5% 5% 0.35%

No Default 95% 95% 6.65%
7.00%

No Default 93% Default 5% 5% 4.65%

No Default 95% 95% 88.35%
93.00%

Joint Probability Matrix (Independent Defaults)

B
Default No Default Total
A

Default 0.35% 6.65% 7.00%

No Default 4.65% 88.35% 93.00%
-------- --------- ----------
Total 5.00% 95.00% 100.00%

Loss Distribution (Independent Case)

Loss Total Cumulative

Probability Probability

A and B default 150 0.35% 100.00%

A defaults 100 6.65% 99.65%
B defaults 50 4.65% 93.00%
Neither defaults 0 88.35% 88.35%

The loss percentile 99.65% is Rs. 100 and loss percentile 93% is Rs.50. The expected loss is 9.50
and the loss volatility is 27.74

Correlated Default Events:

Given a correlation coefficient of 10% between defaults of A and B, the joint default probability
is worked out using the following formula:

P(A,B) = a x b +  [(a)(1  a) x(b)(1  b)]

Where a = Probability that A defaults, b= Probability that b defaults and  =

coefficient of correlation between the defaults of A and B

The joint probability is calculated as 0.9061%

Calculation of Conditional and Joint Probabilities (Correlated Case):

A B Conditional Prob.( B/A ) Joint Prob.

Default 7% Default 5% 12.944% 0.9061%

No Default 95% 87.056% 6.0939%
7.00%

No Default 93% Default 5% 4.4021% 4.0939%

No Default 95% 95.5979% 88.9061%
93.00%

Joint Probability Matrix – Correlated Case

B
Default No Default Total
A
Default 0.9061% 6.0939% 7.00%
No Default 4.0939% 88.9061% 93.00%
-------- --------- ----------
Total 5.00% 95.00% 100.00%

Loss Distribution (Correlated Case)

Loss Total Cumulative

Probability Probability

A and B default 150 0.9061% 100.0000%

A defaults 100 6.0939% 99.0939%
B defaults 50 4.0939% 93.0000%
Neither defaults 0 88.9061% 88.9061%

The expected loss is Rs. 9.50 and the loss volatility is Rs. 28.73. Due to the positive correlation ,
loss volatility has increased from 27.74 to 28.73 while the expected loss remains the same.

Expected and unexpected loss

Expected loss is the average loss in value over a period of time for a given exposure. The expected
loss is best handled by building it into the product price. The unexpected loss refers to the variability
of potential loan loss around the average loss level. The unexpected loss can be viewed as some
multiple of the standard deviation of the expected loss. The essence of credit risk management is
arriving at a good estimate of the unexpected loss