Measuring and Analysing Credit Risk

Measuring and Analysing Credit Risk

DOI: 10.4018/978-1-5225-7280-0.ch003

Abstract

This chapter discusses the measurement and analysis of credit risk. A factory plans to accomplish a project and applies for credit to a bank to finance the project. The bank considers a loan to finance the factory project and assesses the credit risk. The chapter presents the analysis and measurement of different aspects of credit risk in order to answer how much should be lent to the factory project and for how long considering the risk inherent in the transaction. Credit risk is assessed considering: 1) Cash flow projection; 2) Count of negative cash flow; 3) Maximum negative cash flow; 4) Net Present Value (NPV) based on dividends; 5) Internal Rate of Return (IRR) based on dividends; 6) Capital asset NPV and IRR; 7) Solvency loan; 8) Risk of bankruptcy; 9) Financial Analysis Measures such as Gross Margin, Interest Coverage, Financial Coverage, Return on Investment, Return on Assets and Net Worth.
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Introduction

Credit risk is the risk of losses due to borrowers’ default or deterioration of credit standing. Default risk is the risk that borrowers fail to comply with their debt obligations. Default triggers a total or partial loss of the amount lent to the counterparty.

Credit risk also refers to the deterioration of the credit standing of a borrower, which does not imply default, but involves a higher likelihood of default. The book value of a loan does not change when the credit quality of the borrower declines, but its economic value is lower because the likelihood of default increases. For a traded debt, an adverse migration triggers a decline of its quoted price.

Recovery risk refers to the uncertain value of recoveries under default. Recoveries depend on the seniority of debt, on any guarantee attached to the transaction and on the workout efforts of the lender. The loss after workout efforts is the loss given default.

Counterparty credit risk exists when both parties of a transaction are potentially exposed to a loss when the other party defaults. A swap contract exchanging fixed for floating interest flows between two parties is a typical example. The party who receives more than it pays is at risk with the other party. The exposure might shift from one party to the other, and its size varies, as a result of the movements of interest rates. Counterparty credit risk exists when exposures are market driven.

A substantial development of Credit Risk Management happened in the last 40 years or so. For example, a work by Altman & Saunders (1997) traces developments in the credit risk measurement literature over a period of 20 years, from 1977 to 1997. This paper presented the evolution of the literature on the credit-risk measurement of individual loans and portfolios of loans. The paper outlined the reference to articles appearing in relevant issues of the Journal of Banking and Finance and other publications. Also, a new approach built around a mortality risk framework to measuring the risk and returns on loans and bonds is presented. This model is shown to offer some promise in analysing the risk-return structures of portfolios of credit-risk exposed debt instruments.

In their book ‘Managing Credit Risk’, Caouette, Altman & Narayanan (1998) provided a comprehensive review of credit risk management that should be compulsory reading for not only those who are responsible for such risk but also for financial analysts and investors. This book is an important addition to a significant but neglected subject.

The phenomenal growth of the credit markets has spawned a powerful array of new instruments for managing credit risk, but until now there has been no single source of information and commentary on them. In Managing Credit Risk, three highly regarded professionals in the field have-for the first time-gathered state-of-the-art information on the tools, techniques, and vehicles available today for managing credit risk. Throughout the book they emphasise the actual practice of managing credit risk and draw on the experience of leading experts who have successfully implemented credit risk solutions.

Starting with a lucid analysis of recent sweeping changes in the U.S. and global financial markets, this comprehensive resource documents the credit explosion and its remarkable opportunities-as well as its potentially devastating dangers. Analysing the problems that have occurred during its growth period-S&L failures, business failures, bond and loan defaults, derivatives debacles-and the solutions that have enabled the credit market to continue expanding, Managing Credit Risk examines the major players and institutional settings for credit risk, including banks, insurance companies, pension funds, exchanges, clearinghouses, and rating agencies. By carefully delineating the different perspectives of each of these groups with respect to credit risk, this unique resource offers a comprehensive guide to the rapidly changing marketplace for credit products.

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