Credit Risk Is To A Company Essay Example Pdf - Free Essay Example

Definition: Credit Risk is the risk of loss arising from some credit event with counterparty. Who can be the possible counterparty? Counterpart can be Individuals, companies or the government of a country itself. In laymans terms credit risk is the risk that you wont be paid back your money or the the person whom you have lended money or given money for a contract defaults. There can be many types of obligations apart from the currency such as, customer credit to financial derivative transactions. Credit risk also referred to as default risk. In this the obligator does not honor the obligation. Another important term might be credit exposure. This is also known as exposure at default. This tells how much creditor will loose if the counterparty defaulted its obligation What are the models of managing the credit risk? The models are based on the two important concepts: 1. Default Probability 2. Recovery Rate And combiningly they are called credit spread Different types of credit risk Issuer Risk Counterparty Risk Default Risk Creditworthiness Risk The mutual combination creates different types of credit risk which can be placed in the box. Importance of Credit Risk in Capital markets In the absence of analytical information about a companys financial position, many investors in corporate credit markets would stay within the confinements with a lower returns of the banks and the government securities. If investors can be eligible to compare credit risk across companies, industries and countries, the capital market will get a lot of investors in corporate bond market. Reduction or proper evaluation of Credit Risk can help investors to access funds from a various instrument as well as reduces information risk, which eventually helps in efficient pricing. This reduces the cost of capital and allows a larger number of projects to be economically possible, hence enhancing growth of economy. More the number of projects, more is the liquidity in bond market. The banking system inefficiencies are not present in capital market. Hence, proper management of credit risk is very essential in capital markets. The proper evaluation also brings transparency and reduces in formation asymmetry in the Capital market. By this the people get proper incentive to invest in capital market. Also BASEL II requires that credit risk to be included in the definition of the market risk. Introduction to Credit Derivatives Credit derivatives help in transferring the risk of loss in a loan, bond, derivative or other financial obligation from one party to another. They allow institutions to transfer credit risk without buying or selling the underlying asset. Even if a very damaging operational risk is hitting the bank, the credit derivatives help in dispersing the risk. Payouts on credit derivatives depend in some way on the creditworthiness of companies or countries that borrow money either via loans or the issue of bonds. The credit worthiness is recognized by various credit rating agencies. The examples might be Moodys Investors Service or Standard Poors. Credit derivatives though may not appear to have an underlying asset, can be equated to a premium paid to transfer the risk to the third party. Credit Risk Mitigating Mechanisms There are a lot of methodologies for mitigating the risks. Some of them are stock index futures, letter of credits, insurance products, hedging by forward rate agreements, swaps and lot more. But the question now is why credit derivatives are special? Yes. They are special due to the fact that they are helpful in mitigating the risk when economy is in a very bad condition. The commercial risk reducing instruments, instead of offsetting each other, combine to increase the risk in overall. Have a look at the figure below. Mostly helpful in economic down turns, Hence helpful!! Mostly Helpful in economic up-turn Credit Derivatives Guarantees, Letter of Credit, Insurance Products etc Commercial Business Oriented risk mechanisms Financial Risk Mechanisms The credit derivative helps Transferring risk to third party Individual retail clients to invest in bonds and stocks previously unaffordable Individuals to invest in the foreign bonds with lower expenditure Indirect Investing in stock: Helpful for foreign investors who want to buy the domestic bond(Help them to bypass regulatory constraints) Reduce the risk of a start-up financing Split out the company specific risk from the market risk Some of the credit derivative instruments are mentioned below Credit Default Swap Protection Seller Protection Buyer Fee(monthly, quarterly, semi-annually, yearly) Payment contigent on credit event Reference Asset (Bond, default swap or other) Reference: Credit Derivatives: By George Chacko, Anders Sjoman, Hitedo Motohashi, Vincent Dessain Credit Linked Note( Standard Debt Note+ a credit derivative such as credit default swap) Funded Protection Seller Note Issuer (Protection Buyer) Fee(Interest+ CDS Premium) Note Issuer- Seller Payment Bond MNO Proceeds from Note Sale Return on Bond MNO Reference: Credit Derivatives: By George Chacko, Anders Sjoman, Hitedo Motohashi, Vincent Dessain Credit Spread Option This is hedging as well as investment instruments that save against changes in credit spread. A broad Classification of the credit Derivatives is done as below Credit Event Options Swaps Forwards Structured Notes Changes in Credit Spread Credit Spread Option Credit Spread Swap Credit Spread Forward Credit Linked Note Change in Market Value/ Rating Credit Event Option Credit Event Swap Credit Event Forward Credit Linked Note Default Credit Default Option Credit Default Swap Credit Linked Note Traditional Method of Managing Risk other than credit derivative Letters of Credit: Bank guarantees that the buyer of the goods will pay the correct amount on time to the seller. In the case of a buyer fails to fulfil its obligation, bank takes the responsibility to pay in full or partially to the seller according to the norms and conditions. The letter of credit plays a very important role in international trade. Because, it is impossible for the seller to know the credentials of the buyer, which is staying abroad. Hence, a well-known bank takes this responsibility. Insurance Products: The insurance products helps people in mitigating credit risk. Credit Insurance product provides protection to the business, scope of growth, better credit terms and security for bank finacing. One of the examples of such products are Export Credit Insurance. Guarantees: Such instruments include bank guarantee, export credit guarantee, inter-corporate guarantee. Risk Based Pricing: Lenders charge more to borrowers who are more like to default. Lenders consider credit rating of the borrower, purpose of taking loan and the loan to value ratio of the loan. Tightening: Reduce the amount of loan or the time period to maturity of the loan. Diversification: Lenders choose a large number of borrowers with mixed credentials to pay back the borrowed amount. Deposit Insurance: Government establishes it secure the bank deposits in insolvent banks or bankrupt banks. Players in credit derivatives (Buyers and sellers, their role, incentives and risk involved) The players in credit derivative market are divided into two groups. It is interesting to note that the same types of the firms are on the both side, namely, banks, security houses, insurance companies and hedge funds. The most prominent players are the banks and the least prominent player is government. Participation of the corporate in credit derivative market is in mid range. It is noticed that the dominance of the banks in the credit derivative market is decreasing day by day, but they still remain the prominent players. In case of Buyers, Securities Houses and Hedge Funds are in 2nd and third position respectively. Whereas, in sellers, Insurance companies and the Securities Houses are in second and third position respectively. It is a good news that the number of small players are increasing day by day and hence resulting in increase in the liquidity in the credit derivative market. What are the underlying Assets? CorpSovereign Assets(Non-Emerging Markets) Other s Corporate Assets Financials Sovereign Assets(Emerging Markets) orate asset is most used underlying reference asset Risks associated with credit derivatives Jp-to-default risk in case of Credit Default Swap: This is the risk for the seller in case of the default of reference entity. Seller has to pay millions of dollar to the buyer who is protected Bankruptcy Risk: The risk that reference entity will go bankrupt Restructuring Risk: The risk that the reference entity will be restructuredum