Tutorial Week 9- Credit risk measurement PDF

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Chapter 11 Credit risk measurement and management of the loan portfolio A

Solutions to discussion questions

Q1. Outline the problems of traditional lending methods and possible solutions. Are there any problems with the solutions? Original credit risk management was based on human expertise and this was prone to error. To overcome this, statistical models were introduced to “score” credit. This is relatively new and it is unclear if all variables in credit have been captured.

Q2. Compare and contrast the approach of the Z score model and the KMV expected default frequency model. The Z score model uses backward looking financial ratios, which is statistical and not based on a financial theory. On the other hand, KMV uses market values which are forward looking and based on option theory. However, both models cannot distinguish loan maturity, covenants or loan seniority.

Q3. Under what circumstances does KMV’s expected default frequency model not work correctly? A. Since the EDF method is based on an option its value will tend toward zero as the loan approaches maturity. This is the obvious problem, as the credit risk, even though it may be small, does not disappear.

Q4. Explain the limitations of the concept of the risk-adjusted return on capital. A. The risk-adjusted return on capital approach assumes unlimited capital. Therefore, if capital is scarce then the marginal RAROC should be used. In reality, RAROC is really only useful to ensure that a hurdle rate is achieved.

Q5. What financial basis does Altman use to construct his portfolio management model? Why does he use constraints in maximising the return on the portfolio? A. Altman’s portfolio approach utilises the Sharpe Index. However, his constraints are important. The first is ensuring that the weights within the portfolio add up to one. The next two are more important. The second constraint ensures that each loan has a minimum return (and is not unlike RAROC). The third constraint ensures that no one loan becomes a large exposure.

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Q6. Explain the circumstances in which you would use securitisation and the circumstances in which you would use credit derivatives. A. Theoretically, securitisation and credit derivatives should give the same benefits. However in practice they do not. Credit derivatives ensure that the lender maintains a relationship with a borrower. This leads to securitisation being used for essentially retail styled loans and credit derivatives being used for institutional loans. Q7. Is securitisation a credit risk management tool? A. Securitisation can be a credit risk management tool. Most of the time it is not used for credit risk management. Rather it is used for capital or liquidity management. There is a paradox here. Except in the case of large exposures, where the removal of credit risk maybe desirable, lenders would be seeking to remove lesser credits from their balance sheet. However, in most instances, investors reject lesser credits and desire high-quality credits.

Q8. If a protection seller under credit derivatives is assuming the risk of a loan, why does the protection seller not just provide the loan? To agree with this statement is to misunderstand the nature of lending. When a loan is made, a lender commits capital to the loan as well as managing funding risk, liquidity risk, interest rate risk and a number of other risks. Credit risk is only one aspect of the loan. Therefore the protection seller is not making a loan.

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