Credit Risk
Core Concepts
Credit risk is the risk of loss from a counterparty failing to meet its obligations. Candidates must understand the 5 Cs of credit: Character, Capacity, Capital, Collateral, and Conditions. Key measures include probability of default (PD), loss given default (LGD), exposure at default (EAD), and expected loss (EL = PD × LGD × EAD). Credit scoring and rating models assess default likelihood. Credit risk mitigation includes collateral, guarantees, credit derivatives, and netting. Concentration risk arises from exposure to a single counterparty, sector, or region. Counterparty credit risk applies to derivatives and includes credit valuation adjustment (CVA).
Traps in Questions
- Forgetting to multiply by EAD when calculating expected loss.
- Confusing PD (likelihood) with LGD (severity).
- Assuming collateral eliminates risk; it mitigates but introduces legal and operational risks.
- Overlooking wrong-way risk in CVA (exposure increases as counterparty credit quality deteriorates).
Worked Example
A loan of $10 million has PD = 2%, LGD = 40%. Expected loss = 0.02 × 0.40 × $10m = $80,000. If collateral reduces LGD to 20%, EL becomes $40,000. The bank compares this to its risk tolerance for the borrower.
Rule of thumb: EL = PD × LGD × EAD; always check which component a change affects.