Credit Risk Management

Preface xi

PART 1 THE CREDIT RISK FRAMEWORK 1

1 Definitions and Concepts 3

Learning Objectives 3

Introduction 4

What is Credit? 4

Evolution of Credit Markets 7

What is Credit Risk? 10

Building Blocks of Portfolio Risk 14

Default 18

Portfolio Performance Metrics 19

Data and Data Systems 21

Risk Control Framework and Governance 22

2 Active Credit Portfolio Management 27

Learning Objectives 27

Introduction 28

What is ACPM? 28

Mark-to-market Approach 30

Metrics for ACPM 35

Data and Models 37

3 Capital Adequacy Framework 43

Learning Objectives 43

Introduction 44

Capital Adequacy Under Basel I 44

Basel II's Three Pillar Approach 49

Basel III (2010) 53

Capital Adequacy in Hong Kong 54

Implementation Issues 55

PART 2 CAPITAL REQUIREMENTS ON CREDIT RISK UNDER BASEL 59

4 Standardised Approach to Credit Risk 61

Learning Objectives 61

Introduction 62

Standardised Approach to Credit Risk 62

Individual Claims 63

Credit Risk Mitigation 74

Securitization Exposures 84

5 Internal Ratings-Based Approach 89

Learning Objectives 89

Introduction 90

What is the IRB Approach? 90

Building Blocks of the IRB Approaches 92

IRB and Selected Exposures 93

Internal Rating System 106

Validation of IRB Models 114

PART 3 CREDIT RISK AND PORTFOLIO MODELS 123

6 Structural Models 125

Learning Objectives 125

Introduction 126

Basic Structural Model 126

Black-Scholes-Merton 129

Valuation 133

Black-Cox 135

Vasicek-Kealhofer 140

Stochastic Interest Rates 144

Endogenous Default Barrier 145

Corporate Transaction Analysis 146

Liquidity 147

Other Structural Approaches 148

7 Econometric Models 159

Learning Objectives 159

Introduction 160

Discrete-choice Models 160

Hazard Rate (Duration) Models 168

Practical Applications 172

Calibrating Econometric Models 177

Calibrating to Ratings 187

Interpreting the Relative Infl uence of Factors in Econometric Models 192

Data Issues 194

8 Loss Given Default 203

Learning Objectives 203

Introduction 204

Timeline of Default Resolution 204

Measures of LGD 206

Multifactor Approach to LGD 212

Regression Framework 217

9 Reduced-form Models 223

Learning Objectives 223

Introduction 224

Reduced-form Models in Context 225

Basic Intensity Models 228

DSL Framework 237

Credit Rating Transition Models 241

Default Probability Density Version of Intensity Models 247

Generic Credit Curves 253

10 PD Model Validation 259

Learning Objectives 259

Introduction 260

Parameter Robustness 260

Measures of Model Power 263

Measures of PD Levels and Calibration 267

Sample Size and Confi dence Bounds 280

Assessing the Economic Value of More Powerful PD Models 296

Designing Validation Tests 305

11 Portfolio Models 315

Learning Objectives 315

Introduction 316

Measuring Portfolio Diversifi cation 316

Portfolio Risk Assuming No Credit Migration 317

Structural Models of Default Correlation 319

Credit Migration 323

Model of Value Correlation 325

Probability of Large Losses 329

Valuation 332

Return Calculations 334

Risk Calculations 337

Portfolio Loss Distribution 343

Capital 355

Economic Capital and Portfolio Management 358

Improving Portfolio Performance 361

Performance Metrics 364

Reduced-form Models and Portfolio Modelling 368

Correlation in Intensity Models 369

Copulas 371

Integrating Market and Credit Risk 373

Counterparty Risk in CDS and Credit Portfolios 374

Stress-testing 376

PART 4 CREDIT DERIVATIVES AND STRUCTURED CREDIT PRODUCTS 383

12 Credit Derivatives 385

Learning Objectives 385

Introduction 386

What are Credit Derivatives? 386

Credit Default Swap 389

Total Return Swaps 393

Credit-linked Notes 398

Credit Spread Derivatives 399

Pricing Credit Derivatives 401

13 Structured Credit Products 415

Learning Objectives 415

Introduction 416

Securitisation 416

Asset Backed Security 423

Collateralised Debt Obligation 424

Capital Charge Requirements 427

Derivatives and Structured Credit as Risk Management Tools 428

Summary 430

Key Terms 431

Study Guide 431

Further Reading 431

Index 433