CREDIT RISK

MEASUREMENT
Credit Risk Measurement: Concept; Credit Analysis of Corporate
Bonds; Agency Ratings; Modeling Credit Risk; Elements of Credit
Risk; Default Risk; Measuring Default Probabilities; Loss given
Default; Loan Portfolios, Expected Losses & Unexpected Losses;
Credit Derivatives; CLN; CDO; CDS.
 CREDIT RISK
Concept: A credit risk is the risk of default on a debt that may arise
from a borrower failing to make required payments.

In the first resort, the risk is that of the lender and includes lost
principal and interest, disruption to cash flows, and increased
collection costs.
 CREDIT RISK
The loss may be complete or partial. In an efficient market, higher
levels of credit risk will be associated with higher borrowing costs.
Because of this, measures of borrowing costs such as yield spreads can
be used to infer credit risk levels based on assessments by market
participants.
 CIRCUMSTANCES FOR LOSSES
A consumer may fail to make a payment due on a mortgage loan, credit card,
line of credit, or other loan.
A company is unable to repay asset-secured fixed or floating charge debt.
A business or consumer does not pay a trade invoice when due.
A business does not pay an employee's earned wages when due.
 CIRCUMSTANCES FOR LOSSES
A business or government bond issuer does not make a payment on a
coupon or principal payment when due.
An insolvent insurance company does not pay a policy obligation.
An insolvent bank won't return funds to a depositor.
A government grants bankruptcy protection to an insolvent consumer or
business.
 CREDIT RISK
To reduce the lender's credit risk, the lender may perform a
credit check on the prospective borrower, may require the borrower
to take out appropriate insurance, such as mortgage insurance, or
seek security over some assets of the borrower or a guarantee from
a third party.
The lender can also take out insurance against the risk or on-sell
the debt to another company.
 CREDIT RISK
In general, the higher the risk, the higher will be the
interest rate that the debtor will be asked to pay on the
debt. Credit risk mainly arises when borrowers are unable
to pay due willingly or unwillingly.
 CREDIT ANALYSIS OF CORPORATE BONDS

Corporate bonds offer a higher yield compared to some other

investments, but for a price. Most corporate bonds are debentures,
meaning they are not secured by collateral.

Investors of such bonds must assume not only interest rate risk but
also credit risk, the chance that the corporate issuer will default on
its debt obligations.
 CREDIT ANALYSIS OF CORPORATE BONDS

Therefore, it is important that investors of corporate bonds

know how to assess credit risk and its potential payoffs:
while rising interest rate movements can reduce the value
of your bond investment, a default can almost eliminate it.
Holders of defaulted bonds can recover some of their
principal, but it is often very small part of it.
 CREDIT ANALYSIS OF CORPORATE BONDS

Corporate bonds (also called “corporates”) are debt obligations,

issued by privately- and publicly-owned corporations. When you
buy a corporate bond, you essentially lend money to the entity that
issued it. In return for the loan of your funds, the issuer agrees to
pay you interest and to return the original loan amount – the face
value or principal - when the bond matures or is called (the
“maturity date” or “call date”).
 CREDIT ANALYSIS OF CORPORATE BONDS

Unlike stocks, corporate bonds do not convey an

ownership interest in the issuing corporation. Companies
use the funds they raise from selling bonds for a variety of
purposes, from building facilities to purchasing equipment
to expanding their business.
 REASONS FOR BUYING CORPORATES
Attractive yields. Corporates usually offer higher yields
than comparable-maturity government bonds. This higher
yield is, however, generally accompanied by higher risks.

Periodic income. Investors seeking steady income from

their investments, while also preserving their principal,
may include corporates in their fixed income portfolios.
 REASONS FOR BUYING CORPORATES
Diversity. Corporate bonds provide an opportunity to
choose from a variety of sectors, structures, and credit-
quality characteristics to address investment
diversification objectives.

Liquidity. Large and liquid sectors of the corporate bond

market can provide relatively quick and easy
marketability for investors who want to sell a bond before
maturity.
 ISSUANCE FORM
:- Corporate bonds are issued in several forms:
•Registered bonds: - Some corporate bonds are issued as certificates,
with the owner’s name printed on them. There are no coupons attached
for the owner to submit for payment of interest. The issuer’s agent or
trustee sends the interest to the bondholder at the proper intervals, and
forwards the principal at maturity.

Bearer bonds:-These are bonds that have no name printed on them, and
have coupons attached. Anonymous and highly negotiable, bearer bonds
are virtually equivalent to cash. The Tax Reform Act of 1982 ended the
issuance of such bonds in the United States, but some remain in
circulation today.
 ISSUANCE FORM
Book-entry bonds:- The most common form of issuance today,
these are bonds for which certificates are not available to investors.
With book-entry securities, a bond issue has, generally, only one
master, or global, certificate, which is kept at a securities
depository. The investor’s ownership of book-entry bonds is
recorded in the investor’s brokerage account.
The broker, in turn, holds a corresponding interest in the global
certificate that is held by the depository.
All interest and principal payments are forwarded to the depository,
and from there to the brokerage account.
 ISSUANCE FORM
Maturity:- One key feature of any bond is its maturity, the date
until which the bond pays interest and on which it repays the
principal.
Corporate bonds, in general, are divided into three maturity
groups:
Short-term notes: Maturities of up to 5 years
Medium-term notes/bonds: Maturities of 5–12 years
Long-term bonds: Maturities greater than 12 years
 ISSUANCE FORM
Interest Rate Type:- Another important feature of a bond is its structure.
In a traditional bond structure, a specified amount of money is lent to the
issuer for a specified period of time. In exchange, the issuer makes
interest payments on a regular schedule for the life of the bond, with the
full principal returned at maturity. The three types of interest rates that are
the most common are:
Fixed-rate
Floating-rate
Zero-coupon
 TYPES OF INTEREST RATES
Fixed-rate:- Most bonds still pay a traditional fixed interest rate, where a
bond’s interest rate is fixed to maturity.
Floating-rate:- Some bonds pay an interest rate that varies and is typically
adjusted periodically according to an index tied to short-term Treasury bills or
money markets. Such bonds offer protection against future increases in
interest rates, and in exchange their yields are typically lower than those of
comparable fixed-rate bonds.
Zero-coupon:- These bonds that have no periodic interest payments. Instead,
they are sold at a deep discount to face value, and redeemed for the full face
value at maturity, with the difference between that discount and the full face
value representing the interest amount.
 YIELD
Yield:- Yield is the rate of return on your bond investment. Yields vary to
reflect the price movements in a bond caused by changes in prevailing interest
rates, among other factors.
Current yield:- The current yield is the annual return on the dollar amount
paid for a bond, regardless of its maturity. If you buy a bond at par, the current
yield equals its stated interest rate. Thus, the current yield on a par-value bond
paying 6% is 6%.
However, if the market price of the bond is more or less than par, the current
yield will be different.
For example, if you buy a Rs.1,000 bond with a 6% stated interest rate after
prevailing interest rates have risen above that level, you would pay less than
par. Assuming your price is Rs. 900, for example, the current yield would be
6.67% (Rs.1,000 x .06/Rs. 900).
 YIELD
Yield to maturity:- A more meaningful figure is the yield to maturity, which tells
you the total return you will receive if you hold a bond until maturity. It also
enables you to compare bonds with different maturities and coupons. Yield to
maturity includes all your interest to be received until maturity plus any capital
gain you will realize (if you purchase the bond below par) or minus any capital
loss you will suffer (if you purchase the bond above par) at maturity.

Yield to call: - The yield to call tells you the total return you would receive if you
were to buy and hold the security until the call date. As an investor, you should be
aware that this yield is valid only if the bond is called prior to maturity. The
calculation of yield to call is based on the coupon rate, the length of time to the
call date, and the market price of the bond.
 UNDERSTANDING THE RISK
Interest Rate Risk:- Like all bonds, the price of corporates rises when interest
rates fall, and fall when interest rates rise. Generally speaking, the longer a
bond’s maturity, the greater the degree of price volatility.
An investor holding a bond until maturity may be less concerned about these
price fluctuations (which are known as interest-rate risk, or market risk),
because he or she will receive the par, or face, value of the bond at maturity.
Investors should be aware of the inverse relationship between bond prices and
interest rates — that is, the fact that bonds are worth less when interest rates
rise. But the explanation is essentially straight forward:
When interest rates rise, new issues come to market with higher coupon rates
than older securities, making those older ones less attractive in comparison.
Hence, their prices go down.
 UNDERSTANDING THE RISK
When interest rates decline, new bond issues come to market with lower
coupons than older securities, making those older, higher coupon bonds more
attractive. Hence, their prices go up.
As a result, if an investor sells a bond before maturity, it may be worth more
or less than at the time of purchase.

Various economic forces affect the level and direction of interest rates in the
economy. Interest rates typically climb when the economy is growing, and fall
during economic downturns. Inflation is one of the most influential forces on
interest rates; rising inflation leads to rising interest rates, and moderating
inflation leads to lower interest rates Redemption Risks.
 UNDERSTANDING THE RISK
Call features:- A bond’s indenture (the legal document that spells out its terms and
conditions) may contain a “call” feature. This provision gives the bond issuer the
right to retire, or redeem, the bond, fully or partially, before the scheduled maturity
date. For the issuer, the chief benefit of such a feature is that it may permit the issuer
to replace outstanding debt with a lower coupon rate new issue if interest rates
decline in the future.
Sinking-fund provisions:- A sinking fund is money taken from a corporation’s
earnings that is used to redeem bonds periodically, before maturity, as specified in the
indenture. If a bond issue has a sinking- fund provision, a certain portion of the issue
must be retired each year. The bonds retired are usually selected by lottery. One
investor benefit of a sinking fund is that it lowers the risk of default by reducing the
amount of the corporation’s outstanding debt over time. Another is that the fund
provides price support to the issue, particularly in a period of rising interest rates.
However, the disadvantage is that bondholders may receive a sinkingfund call at a
price (often par) that may be lower than the current market price.
 UNDERSTANDING THE RISK
Other types of redemptions:- Bond investors should be aware of the
possibility of certain other kinds of calls or redemptions prior to maturity.
Some bonds, especially utility securities, may be called under what are known
as Maintenance and Replacement fund provisions (which relate to upgrading
plant and equipment).
Puts:- Just as some issuers have the right to call their bonds prior to maturity,
some bonds include a provision granting investors the option to “put,” or
redeem, the bond prior to maturity. At specified intervals, investors may “put”
the bond back to the issuer for full face value plus accrued interest. In
exchange for this privilege, such bonds have a somewhat lower yield than a
comparable bond without a put feature. Credit risk. Credit risk is the potential
for loss resulting from an actual or perceived deterioration in the financial
health of the issuing company. Two subcategories of credit risk are default risk
and downgrade risk.
 UNDERSTANDING THE RISK
Default Risk:- Defaults occur when a company fails to pay an interest or
principal payment to a debt holder as scheduled and as specified in its
indenture. The risk of default on principal or interest, or both, is greater for
high-yield bonds than for investment-grade bonds. Factors that may lead to
default include business cycle volatility, excessive leverage or threats from
competitors. In a corporate bankruptcy or dissolution, although secured
bondholders and holders of senior debt issues may receive some distribution
of corporate assets, it is rarely enough to “make whole” their total investment.
Bonds of companies in default may trade at very low prices, if they trade at
all, and liquidity may disappear.
 UNDERSTANDING THE RISK
Downgrade risk:- Downgrades result when a rating agency lowers its rating
on a bond or the company that issued a bond; for example, a change by
Standard & Poor’s from a B to a CCC rating. Downgrades are usually
accompanied by bond price declines. In some cases, the market anticipates
downgrades by bidding down prices prior to the actual rating agency
announcement. Before bonds are downgraded, agencies often place them on a
“creditwatch” status, which also tends to cause price declines.
 UNDERSTANDING THE RISK
Liquidity risk:- Liquidity risk refers to the investor’s ability to sell a bond
quickly and easily, as reflected in the size of the bid-ask spread, or the
difference between the price at which buyers are willing to buy (the bid) and
the price at which sellers are willing to sell (the ask) a bond. That spread is
usually quite small for large, actively traded bond issues, reflecting ample
liquidity. A wider spread indicates, among other things, greater liquidity risk.
High-yield bonds may be less liquid than investment-grade bonds, depending
on the issuer and the market conditions at any given time.
 UNDERSTANDING THE RISK
Economic risk:- Economic risk describes the vulnerability of a bond to
downturns in the economy. Virtually all types of high-yield bonds are
vulnerable to economic risk. In recessions, high-yield bond prices typically
fall more than investment-grade bonds, a reflection of their credit quality.
When investors grow anxious about holding lower credit quality bonds, they
may trade them for the higher- quality debt, such as U.S. Treasuries and
investment-grade corporate bonds. This “flight to quality” particularly impacts
high-yield issuers.
 UNDERSTANDING THE RISK
Company and industry “event” risk:- Event risk encompasses a variety of
pitfalls that can affect a company’s ability to repay its debt obligations on
time. These may include poor management, changes in management, failure to
anticipate shifts in the company’s markets, rising costs of raw materials,
regulation and new competition. Events that adversely affect a whole industry
can have a blanket effect on all the bonds in that sector.
 CREDIT RATINGS
In the United States, major rating agencies include Moody’s Investors Service,
Standard & Poor’s Corporation and Fitch Ratings. Each agency assigns its
ratings based on analysis of the issuer’s financial condition and management,
economic and debt characteristics, and the specific revenue sources securing
the bond. The highest ratings are AAA (S&P and Fitch Ratings) and Aaa
(Moody’s).
Bonds rated in the BBB-/Baa3 category or higher are considered investment-
grade; bonds with lower ratings are considered high yield, or speculative.
Lower ratings are indicative of a bond that has a greater risk of default than a
bond with higher ratings. It is important to understand that the high interest
rate that generally accompanies a bond with a lower credit rating is being
provided in exchange for the investor taking on the risk associated with a
higher likelihood of default.
 CREDIT RATINGS
The rating agencies make their ratings available to the public through their ratings
information desks and online through their respective websites. In addition, their
published reports and ratings are

available in many local libraries. Usually, rating agencies will signal they are
considering a rating change by placing the bond on CreditWatch (S&P), Under
Review (Moody’s) or on Rating Watch (Fitch Ratings).
Not all credit rating agency evaluations result in the same credit rating, so it is
important to review all available credit ratings. It is also important to read the
credit reports and related updates to properly evaluate the underlying credit risks.
You should bear in mind that ratings are opinions, and you should understand the
context and rationale for each opinion. Investors should not rely solely on credit
ratings as a measure of credit risk, but instead use a multitude of resources to assist
in their evaluation and decision making.
 MODELING CREDIT RISK
Credit risk modelling tries to answer the question:
Assuming past behavior is predictive of future behavior, what
is the probability that a debtor will not repay the debt holder?
Credit risk modeling can address any number of
concerns, including:
Internal capital adequacy assessment
External reporting
Risk-based pricing
Performance management
Acquisition/divestiture analysis
 MODELING CREDIT RISK
Also, credit risk modeling is not an exact science, notes quantitative risk analyst
Mikhail Voropeav: “Risk- based, real-time pricing remains the ultimate challenge,”
he writes, because of the challenge of providing accurate, stable, and time-efficient
input. Voropeav highlights another, often-overlooked issue, “the sometimes overly
complex structure of the models as perceived by end users. Very often the
complexity of the models makes them hard to be understood and, hence, affects
their acceptance within an organization.”

As a result, credit unions should realize the importance of acquiring user-friendly

credit risk modeling software, establishing internal reporting protocols and
standards, and allowing substantial time for skilled employees to regularly review
and adjust modeling parameters and triggers to the benefit of the credit union’s
loan portfolio.
 MODELING CREDIT RISK
Model
Calculating credit score (a.k.a risk rating) is an important part of credit risk
modelling. The other important parts are:
PD model (Probability of default) - A model that forecasts whether a particular
borrower will default on the loan
LGD model (Loss given default) - If the borrower default, the lender can recover
some amount by selling the collateral. A common example is: borrower default on
mortgage, so lender forecloses the house and the sale of the house lowers the actual
loss. So if borrower defaulted while owing a mortgage balance of 100k, and the
house was sold through foreclosure for 50k, then lGD = 50/100 = 50%, because the
lender lost 50% of the balance.
EAD model (Exposure at Default) - A model that tries to predict, what will be the
amount owed at time of default (100k in above example)
 ELEMENTS OF CREDIT RISK

LOAN POLICY
The loan policy is the foundation for maintaining sound asset
quality because it outlines the organization’s default risk
tolerances, states terms to mitigate exposure at default, and
provides key controls to help the lending institution identify,
manage, and report risk mitigation. Generally, the loan

policy outlines risk tolerances at the transactional and portfolio

level. At a minimum, every loan policy should accomplish the
following:
 SOUND UNDERWRITING STANDARDS
Describe both desirable and undesirable loans.
Provide underwriting standards and monitoring requirements for
all loans the bank offers and extends. It is important to delineate
primary risk mitigation strategies by transaction and by portfolio.
Establish concentration limits and sublimits. The policy should
also describe enhanced monitoring and underwriting practices
such as management information systems granularity, stress
testing, market and industry analyses, systemic dependency, and
credit reviews.
Describe the credit approval process, identifying lending
authorities and outlining the responsibility of the board in
reviewing, ratifying, and approving loans.
 SOUND UNDERWRITING STANDARDS
Define transactions requiring credit memorandums.
Define transactions requiring audited, reviewed, or compiled
financial statements.
Define transactions requiring environmental audits.
Establish credit and collateral file maintenance standards.
Provide specific documentation requirements for all loan types
offered or extended.
Establish guidelines for insider transactions, including overdrafts,
to ensure compliance with Regulation.
Establish appraisal guidelines to ensure compliance with
Regulation Y and the Uniform Standards of Professional Appraisal
Practices.
 SOUND CREDIT RISK MANAGEMENT AND MONITORING

Establish an effective loan review system and address key

elements of an effective loan review program (such as
qualifications and independence of loan review personnel;
frequency, scope, and depth of reviews; the review of findings and
follow-up; and work paper and report distribution).
Establish a comprehensive and effective credit-grading system.
Create portfolio mix and risk diversification guidelines and limits.
Establish collection and problem loan resolution procedures.
Establish charge-off and nonaccrual policies.
SOUND CREDIT RISK MANAGEMENT AND MONITORING

Establish the methodology for determining the adequacy of the

allowance for loan and lease losses (ALLL). It should also ensure
compliance with Accounting Standards Codification and regulatory
guidance.
Establish a threshold for annual credit reviews to assess the
financial strength of borrowers.
Establish procedures to identify, approve, monitor, and report all
loan policy exceptions with acceptable risk mitigants. Additionally,
the loan policy should set risk tolerances for total policy
exceptions.
SOUND CREDIT RISK MANAGEMENT AND MONITORING

The loan policy should be tailored to the organization and reflect the local/regional
economic conditions and credit needs. At least annually, the board should review
and revise the policy and communicate the policy to all appropriate personnel.
Deviations from the loan policy should not be recurring or excessive and should be
reported (by policy exception and in the aggregate) to the board of directors.
 DEFAULT RISK
Exposure to loss due to non-payment by a borrower of a
financial obligation when it becomes payable. Default risk is
related to the credit worthiness of the borrower and is taken
into account when setting interest rate on the requested loan.
 DEFAULT RISK- SIGNIFICANCE
Default risk can change as a result of broader economic changes or changes
in a company's financial situation. Economic recession can impact the
revenues and earnings of many companies, influencing their ability to make
interest payments on debt and, ultimately, repay the debt itself. Companies
may face factors such as increased competition and lower pricing power,
resulting in a similar financial impact. Entities need to generate sufficient net
income and cash flow to mitigate default risk.

In the event of a default, investors may lose out on periodic interest

payments and their investment in the bond. A default could result in a 100%
loss on investment.
 INDICATIONS OF INCREASED
DEFAULT RISK
Lenders generally examine a company's financial statements and employ several
financial ratios to determine the likelihood of debt repayment.
Free cash flow is the cash that is generated after the company reinvests in itself
and is calculated by subtracting capital expenditures from operating cash flow. Free
cash flow is used for things such as debt and dividend payments. A free cash flow
figure that is near 0 or negative indicates that the company may be having trouble
generating the cash necessary to deliver on promised payments. This could indicate
higher default risk.
The interest coverage ratio is calculated by dividing a company's earnings before
interest and taxes (EBIT) by its periodic debt interest payments. A higher ratio
suggests that there is enough income generated to cover interest payments. This
could indicate lower default risk.
 MEASURING DEFAULT PROBABILITIES
Probability of default (PD) is a financial term describing the
likelihood of a default over a particular time horizon. It provides
an estimate of the likelihood that a borrower will be unable to
meet its debt obligations.

PD is used in a variety of credit analyses and risk management

frameworks. Under Basel II, it is a key parameter used in the
calculation of economic capital or regulatory capital for a banking
institution.

PD is closely linked to the Expected Loss, which is defined as the

product of the PD, the Loss Given Default (LGD) and the
Exposure at Default (EAD).
Expected loss is the value of a possible loss times the
probability of that loss occurring.
 LOSS GIVEN DEFAULT (LGD)
In banking lending (homes, autos, credit cards, commercial lending, etc.) a third concept is
introduced to emphasize that most loans are repaid over time and therefore have a
declining outstanding amount to be repaid. Additionally, loans are typically backed up by
pledged collateral whose value changes differently over time vs. the outstanding loan
value. In banking the three factors are:
Loss given default (LGD)
"magnitude of likely loss on the exposure, expressed as a percentage of the exposure"
Probability of default (PD)
"probability of default of a borrower"
Exposure at default (EAD)
"amount to which the bank was exposed to the borrower at the time of default, measured in
currency"
Loss given default or LGD is the share of an asset that is lost if a borrower defaults.
 LOSS GIVEN DEFAULT (LGD)
It is a common parameter in Risk Models and also a parameter used in the
calculation of Economic Capital, Expected loss or Regulatory Capital under Basel
II for a banking institution. This is an attribute of any exposure on bank's client.
Exposure is the amount that one may lose in an investment.
The LGD is closely linked to the Expected Loss, which is defined as the product of
the LGD, the Probability of Default (PD) and the Exposure at Default (EAD).

LGD is the share of an asset that is lost when a borrower defaults. The recovery
rate is defined as 1 minus the LGD, the share of an asset that is recovered when a
borrower defaults.
Loss given default is facility-specific because such losses are generally understood
to be influenced by key transaction characteristics such as the presence of
collateral and the degree of subordination.
 EXPOSURE AT DEFAULT OR (EAD)
Exposure at default or (EAD) is a parameter used in the calculation
of economic capital or regulatory capital under Basel II for a banking
institution. It can be defined as the gross exposure under a facility upon
default of an obligor.

Outside of Basel II, the concept is sometimes known as Credit

Exposure (CE). It represents the immediate loss that the lender would
suffer if the borrower (counterparty) fully defaults on his debt.

The EAD is closely linked to the expected loss, which is defined as the
product of the EAD, the probability of default (PD) and the loss given
default (LGD).
 LOAN PORTFOLIOS MANAGEMENT
The loans that a lender (or a buyer of loans) is owed. The loan portfolio
is listed as an asset on the lender's or investor's balance sheet. The
value of a loan portfolio depends on both the principal and interest
owed and the average creditworthiness of the loans.

Loans that have been made or bought and are being held for
repayment. Loan portfolios are the major asset of banks, thrifts, and
other lending institutions. The value of a loan portfolio depends not
only on the interest rates earned on the loans, but also on the quality or
likelihood that interest and principal will be paid.
 LOAN PORTFOLIOS MANAGEMENT
Loan portfolio management strategies vary by institution and by country.
However, there are a few basic principles that apply universally. Here are seven of
them:
Understand two major principles of risk:
 Stuff happens
 You don’t know what you don’t know.
You have to anticipate events that could happen and be positioned for
unanticipated events.
Loan portfolio management is only one aspect of overall risk management
Look at LPM from the perspective of Enterprise Risk Management. Look at all of
the risks your organization faces. How you manage your loan portfolio depends on
your level of capital, amount of expected earnings, economic outlook, and a variety
of other factors.
 LOAN PORTFOLIOS MANAGEMENT
Know your organization’s risk position and appetite for risk
Prepare a survey to identify major risks. Establish ratings for each identified risk
along three parameters:
 Significance of risk. How much damage will be caused if the event happens?
 Likelihood of risk event occurring. What are the chances that this event will
happen?
 Ability to manage the risk. Is the risk something that can be easily anticipated and
managed? Have your directors and managers participate in the survey and discuss
the results with everyone.
Build risk management principles into your strategic plan
Your strategic plan should be the foundation for policies, goals, targets, and
underwriting standards. Run stress testing scenarios to better understand what
happens when things don’t go according to plan.
 LOAN PORTFOLIOS MANAGEMENT
Monitor key performance indicators and share the results
Sunlight is the best disinfectant. Make sure everyone in the organization can see
how the organization is doing and progressing. Develop an easy to understand
dashboard to highlight what is working well and what needs improving.
Have a rigorous, independent review process
Have an internal auditor/credit reviewer who reports directly to the board and
senior management. You want to find problems early while they can still be fixed.
Never fool yourself. Also have an external auditor/credit reviewer to check on the
internal processes.
 LOAN PORTFOLIOS MANAGEMENT
None of the actions or strategies above make any difference unless there is a
culture of trust and respect
Make sure you have a culture of trust and respect. Employ people who are
competent, well-trained, and have demonstrated a set of values that include trust
and respect. Good people make loan portfolio and risk management work. It is the
foundation upon which everything else rests.
Loan portfolio and risk management is not just about avoiding risk. It is also about
balancing risk with reward, making sure you are seizing opportunities in your
marketplace and serving your community well. So, go for the opportunities while
balancing your risk management strategy with these seven points. It can help make
your organization even more successful.
 CREDIT DERIVATIVES
Credit derivative refers to any one of various instruments and
techniques designed to separate and then transfer the credit risk or the
risk of an event of default of a corporate or sovereign borrower,
transferring it to an entity other than the lender or debt holder. Simply
explained it is the transfer of the credit risk from one party to another
without transferring the underlying.
They are the negotiable bilateral contracts (reciprocal arrangement
between two parties to perform an act in exchange of the other parties
act) that help the users to manage their exposure to credit risks. The
buyer pays a fee to the party taking on the risk.
 TYPES OF CREDIT DERIVATIVES
Unfunded credit derivatives.
Funded credit derivatives.
 UNFUNDED CREDIT DERIVATIVES
It is a contract between two parties where each is responsible of
making the payments under the contract. These are termed as unfunded
as the seller makes no upfront payment to cover any future liabilities.
The seller makes any payment only when the settlement is met.
Ultimately the buyer takes the credit risk on whether the seller will be
able to pay any cash / physical settlement amount. Credit Default Swap
(CDS) is the most common and popular type of unfunded credit
derivatives.
 FUNDED CREDIT DERIVATIVES
In this type, the party that is assuming the credit risk makes an initial
payment that is used to settle any credit events that may happen going
forward. Thereby, the buyer is not exposed to the credit risk of the
seller. Credit Linked Note (CLN) and Collateralized Debt Obligation
(CDO) are the charmers of the funded credit derivative products. These
kinds of transactions generally involve SPVs for issuing / raising a debt
obligation which is done through the seller.
The proceeds are collateralized by investing in highly rated securities
and these note proceeds can be used for any cash or physical
settlement.
FUNDED CREDIT DERIVATIVES

Unfunded Credit Derivatives Funded Credit Derivatives

1. Credit default Swap (CDS) 1. Credit linked note (CLN)
2. Credit default swaption 2. Constant Proportion Debt Obligation (CPDO)
3. Credit spread option 3. Collateralized debt obligation (CDO)

4. Total return swap 6. CDS on Asset backed securities

 UNFUNDED CREDIT DERIVATIVES
Credit default Swap (CDS):
The most popular form of unfunded credit derivative is Credit Default Swap
(CDS).
In a credit default swap, the seller negotiates an upfront or continuous fee, in order
to compensate the buyer when a specified event, such as default or failure to make
a payment occurs.
The benefit to the buyer and the seller in CDS is that the buyers can remove risky
entities from their balance sheets without having to selling them while the sellers
can gain higher returns from investments by entering markets which are otherwise
difficult for them to get into.
 UNFUNDED CREDIT DERIVATIVES
CDS are mainly of four types:
 Credit default swaps on single entities: In this form, the swap is on a single
entity
 Credit default swaps on a basket of entities: In this the swap is on a bunch of
entities combined
 Credit default index swaps: this includes a portfolio of single entity swaps
 First-loss and tranche-loss credit default swaps: In this type, the buyer is
compensated for any losses from the credit events unlike that in the first loss
credit default swap which only compensates the loss from the first credit event
Finally, the value of a default swap depends on the probability of entity or the
counterparty or the correlation between them.
 UNFUNDED CREDIT DERIVATIVES
Credit default swaption:
Credit default swaption or credit default option is an option to buy
protection (payer option) or sell protection (receiver option) as a credit
default swap on a specific reference credit with a specific maturity.

Simply put it is an option on a CDS. It gives the holder a right and not
obligation to buy / sell protection for an entity for specified future time
period.
 UNFUNDED CREDIT DERIVATIVES
Credit spread option:
A credit spread, or net credit spread, involves a purchase of one option and a sale
of another option in the same class and expiration but different strike prices.
Investors receive a net credit for entering the position, and want the spreads to
narrow or expire for profit. (Wikipedia)
Total return swap:
It is defined as the total transfer of both the credit risk and market risk of the
underlying asset. The assets commonly are bonds, loans and equities.
CDS index (CDSI) products
It is a credit derivative used to hedge credit risk or to take a position on a basket of
credit entities. CDSI is a standardized credit security unlike a CDS which is an
OTC derivative.
 UNFUNDED CREDIT DERIVATIVES
Asset backed CDS (ABCDS):
The reference asset in this case is an asset backed security rather than
any corporate credit instrument.
FUNDED CREDITDERIVATIVES
CREDIT LINKED NOTE (CLN): It is structured as a security with an
embedded CDS allowing the issuer to transfer a specific credit risk to
credit investors. In this case the issuer is not obligated to repay the debt
if a specified event occurs. The ultimate purpose of the CLN is to pass
on the risk of specific default to the investors who are willing to bear
the risk in return for higher yield.
 FUNDED CREDIT DERIVATIVES
CREDIT LINKED NOTE (CLN): It is structured as a security with an
embedded CDS allowing the issuer to transfer a specific credit risk to credit
investors. In this case the issuer is not obligated to repay the debt if a
specified event occurs. The ultimate purpose of the CLN is to pass on the
risk of specific default to the investors who are willing to bear the risk in
return for higher yield.
Constant Proportion Debt Obligation (CPDO):
CPDO is a complex financial instrument, invented in 2006 by ABN Amro
and designed to pay the same high interest rate as a risky junk bond while
offering the highest possible credit rating. It is defined as a type of synthetic
collateralized debt instrument that is backed by a debt security index. These
are credit derivatives for the investors who are willing to take exposure to
credit risk.
 FUNDED CREDIT DERIVATIVES
Collateralized debt obligation (CDO):
It is a type of structured asset backed security (ABS). The CDO is
divided into tranches through which the flow of payments is controlled.
The payments and interest rates vary with the tranches with the most
senior one paying the lowest rates and the lowest tranche paying the
highest rates to compensate for the default risk. Synthetic CDOS are
credit derivatives that are synthesized through basic CDs like CDSs
and CLNs. These are divided into credit tranches based on the level of
credit risk.
FUNDED CREDIT DERIVATIVES

Benefits of Credit derivatives Risks of Credit Derivatives

1. Enable the lenders / investors to take 1. It could lead to increased leverage and
the credit risk as per capacity risk taking by investors

2. Help in enhancing the market 2. markets need to be liquid to manage

efficiency and liquidity risk through CDs

3. They act as financial shock absorbers 3. It may not always channel risk to those
for the who best

economy understand / handle it

4. Creates macroeconomic and financial stability 4. New instruments keep appearing constantly andare
not always tested
 CONCLUSION
With the set of pros and cons involved in credit derivatives, investors
should measure and manage counterparty risks, correlations and
liquidity. Building a strong financial shock absorber is a key element
for ensuring financial stability.