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CrTAS: Credit Risk Analysis and Counterparty Exposure

CrTAS · Work through your exam, one topic at a time.

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Credit Risk Analysis and Counterparty Exposure

Credit Risk Analysis and Counterparty Exposure

This domain tests PD, LGD and EAD mechanics, expected loss, structural credit models, and the counterparty layer: exposure profiles, netting, collateral and CVA. Expect one calculation and one conceptual question on wrong-way risk or CVA hedging.

Core building blocks

  • PD: probability of default over a horizon, usually one year; through-the-cycle versus point-in-time.
  • LGD = 1 minus recovery rate; typically 40-45% for senior unsecured corporate exposure.
  • EAD: drawn balance plus credit conversion factor times the undrawn commitment.
  • Expected loss = PD x LGD x EAD. Expected loss is covered by pricing and provisions; unexpected loss by capital.
  • Merton model: equity is a call on firm assets; default occurs when asset value falls below debt, and distance to default drives PD.

Counterparty credit risk

Exposure = replacement cost plus potential future exposure; EPE is the time-average of expected exposure. Netting compresses exposure within a legal netting set to a single net figure. Margin agreements - variation margin with thresholds and a minimum transfer amount, plus initial margin - cut exposure further but add collateral and liquidity operations burden. CVA is the market value of counterparty default loss and is hedged with CDS; DVA is the mirror image from own default and is controversial. Wrong-way risk: exposure rises as counterparty credit quality falls, for example buying protection on a bank from that same bank.

Worked example

A corporate facility: $40m drawn and $10m undrawn at a 40% CCF, so EAD = 40 + (0.40 x 10) = $44m. One-year PD 0.8%, LGD 45%, so EL = 44 x 0.008 x 0.45 = $158,400, or 0.36% of EAD. If the relationship generates $400k of spread and fees, it covers EL about 2.5 times before capital cost. But if the undrawn line is likely to be drawn precisely as the borrower deteriorates, the CCF is understated and so is EL.

Traps

  • Applying the CCF to the drawn balance instead of the undrawn commitment.
  • Mixing PD and LGD units, or applying LGD as a percentage of PD.
  • Ignoring netting and collateral when computing EAD, or counting both twice.
  • Treating DVA as a risk-free funding benefit.
  • Missing wrong-way risk because exposure and credit quality were modelled independently.