Credit and Counterparty Risk
Credit risk fundamentals
Credit risk is loss from a counterparty failing to meet obligations. Core elements are probability of default, exposure at default, loss given default, and maturity. Expected loss equals probability of default times exposure at default times loss given default. Credit assessment covers capacity, capital, collateral, conditions, and character, supported by ratings, financial analysis, and covenant design.
Counterparty and concentration risk
Counterparty risk is credit risk on derivatives and securities financing, complicated by potential future exposure and wrong-way risk, where exposure rises as the counterparty's credit quality falls. Concentration risk arises from single names, sectors, or correlated collateral, and is often invisible in aggregate averages.
Traps to watch
- Collateral reduces loss given default but introduces market, liquidity, and legal risk.
- A high credit rating does not remove wrong-way risk in structured exposures.
- Netting benefits depend on enforceable legal agreements and jurisdiction.
- Provisioning based only on historical default rates understates risk in rapid deterioration.
Worked example
A loan of 10 million has a 2% one-year probability of default and, after collateral recovery, a loss given default of 40%. Expected loss is 10 million x 0.02 x 0.40 = 80,000. If collateral is illiquid and its value falls in stress, loss given default rises, so the exam answer must reflect the stressed assumption rather than the base case.