Economic capital is the amount of money needed to survive in the worst case

scenario at a given time. Regulatory capital is the minimum amount of capital

that a bank needs to maintain under the relevant regulations to be legally
entitled to perform its operations. Bank capital is the accounting value of the
capital held by an institution. Equity capital of a firm.
Two main approaches to economic capital are top-down approach and
bottom-up approach.
Top-down
o The value of capital (expected earnings are constant) is Expected
Earnings divided by the required return associated with the riskiness of
earnings.
o Economic capital can also be calculated based on the ability to sustain
a worst-case loss at a given confidence level and hence can be
expressed as EC0= EaR/k
o EaR- The difference between expected earnings and the earnings
under the worst-case scenario for a given confidence level.
o Option-Theoretic Approach
This assumes that the market value of capital can be modeled
as call option on the value of the firms asset where the strike
prices the notional value of liabilities.
Bottom-approach
Advanced statistical models are used to model individual
transaction and businesses in order to aggregate risks and to
estimate economic capital. To estimate the economic capital at
the enterprise level, the risk is consolidated at the two levels.
The Basel Committee on Banking Supervision (1988) instituted minimum
levels of capital to be held by internationally active banks against financial
risks. The accord set a minimum level of risk capital expressed as a ration of
capital to the total risk-weighted assets, which include on-balance and offbalance sheet items. It required banks to maintain a capital ratio of at least
8% of its total risk-weighted assets.
o The 1996 Amendment to the Accord introduced a capital charge for
market risk. Trading book (Market Risk), Banking Book (Currency and
commodity risk).
o Capital Ratio= Total Capital/(Credit Risk+ Market Risk+ Operational
Risk)= 8% minimum
Tier 1: Paid up share capital/ common stock. Disclosed reserves
Tier 2: Undisclosed reserves, hybrid capital instruments,
subordinated debt.
Tier 3: Short-term subordinate debt, when can be considered for
the sole purpose of meeting a part of the capital requirements
for market risk.
Credit Risk-weighted assets+ 12.5*(market risk capital
+operational risk)= Total risk-weighted assets
o Pillar II

The second pillar of the new Accord is a set of guiding principles

for supervisors to assess the capital adequacy of banks under
stress scenarios and to take appropriate actions in response to
those assessments.
In absence of a universally accepted method of allocating
economic capital to a portfolio, risk contribution tools are
applied for economic capital allocation decisions.
Stand-alone EC contributions: A business or portfolio
considered independent.
Incremental EC contributions: Considering everything else
to be the same, this method assumes that the EC
allocated to a unit should equal the amount of capital
released when the business unit sold or added.
Marginal EC contributions: Captures the capital to be
allocated for a business unit, when it is considered as a
part of the whole firm.
RAROC and EAR allow the measurement of return on risk capital
not the banks actual capital.
Purely Passive Approach
o Bank calculates capital requirements, but does not
link these to performance, compensation or
business planning.
Semi-active Approach
o Bank starts to use capital requirements in the
planning process, setting targets or limits for
individual businesses.
Active Approach
o Bank has clear allocation of capital for individual
businesses
Economic Capital
An extreme move in market prices
A significant loss resulting from the default of one or more
of the banks trading partners or borrowers
Fraud
Loss of reputation
Hurdle rate is an IRR in a discounted cash flow analysis, above
which an investment makes sense.
RAPM= (Net return- Expected loss-Cost of tied up capital)/
Risk capital
Market Risk
Identification
Assessment
Monitoring
Control/Mitigation

VaR

Primary risks: net long or short positions in various asset

classes.
Secondary risks: exposures to volatility changes and
larger than expected underlying asset price movements.
Many trading books are managed actively with the purpose of
reducing primary risks at the expense of an increase in
secondary risks.
Distinction of general vs specific risk
Proportion of options in trading book
All assets and liabilities are generally held till the contracted
term called maturity. If the contracted terms of assets and
liabilities dont become co-terminus, there could be a difficulty in
meeting the call for liquidity the liabilities. If it is predictable, it
cannot be uncertain. Interest risk is the risk that arises for bond
owners from the fluctuating interest rates.
We are X percent certain that we will not lose more than V
dollars in the next N days. V is the absolute amount or
percentage of interest rates. In general, when N days is the time
horizon and X% is the confidence level. VaR is the loss
corresponding to the (100-x)th percentile of the distribution of
the change in the value of the portfolio over the next N days.
Trading Book
The trading book consists of assets held for short periods,
which may be less than six months or up to one year.
However, the exception to this rule is derivatives, as
swaps and other liquid assets are often held over longer
periods.
Banking Book
The banking book comprises of loans, deposits and the
investment portfolio (which consists of debt securities,
shares and variable yield instruments). In the past, VaR
has been extensively used for the Trading Book.
VaR Models
The Parametric approach (invNorm(x) as in the loss
corresponding to the (100-x)th percentile) * Daily Volatility
(Daily Volatility * sqrt (250)= Annual Volatility)* Position
Value in USD)
Historical Simulation (Historical data can be used to
generate the future. Used to compute VaR))
(homoscedastic)
Monte Carlo Simulation
o Volatility

EWMA and GARCH models (Mean Reversion)

do not assume homoscedasticity. Serial
correlation can be present in financial asset
return series. (Write EWMA and GARCH). The
parameters are estimated by maximizing the
likelihood function.
Principal Component Analysis
A method that transforms a set of correlated variables
into a new set of uncorrelated variables called Principal
Components where the first few PCS describe as much
variation as possible of the original variables. This enables
working with a much smaller set of variables, still
explaining most of the variance. PCA applied to Monte
Carlo VAR could decrease the required number of
scenarios by lowering the dimensionality. Only a few
components are needed to explain 95% of the variation
observed historically.
Stress Testing
A method for the quantification of potential future
extreme adverse outcomes in a portfolio of financial
instruments
A palliative for the anxiety that is experienced by
managers with significant risk exposures.
Per recommendation 6 of G-30 report.
o Historical Approach
The actual crisis event is used
These are real events that happened in the
past
o Hypothetical Scenarios
Covariance Matrix
Create event
Sensitivity Analysis (Granularity= Increment;
Range= Resultant Change in the Market)
o Algorithmic Scenarios
Factor Push
The risk factors are pushed in the
most disadvantageous directions then
the combined effect of all charges on
the value of the portfolio is estimated
Maximum loss
It is the procedure of searching over
the losses that can occur for all
feasible values of the risk actors.
Worst-case scenario analysis

Over a horizon of several days, the

worst-case scenarios could be the loss
associated with the most adverse daily
outcome.
The Extreme Value Theory
Theory of large losses asses the risk of highly
unusual events; helps predict the amounts of
large insurance losses, and predict equity
risks.
Block Maxima: Events are picked
considering the largest in a certain
specified period. Satisfying the
Generalized Extreme Value
distribution.
Peak-over-threshold Approach: Events
are selected based on a threshold and
ignoring time. Generalized Pareto
Distribution.
Expert judgment is looked for to
identify the scenarios. Desk level
stress test traders perform to know
the position-by-position risk level.

Liquidity

A company is said to be liquid when it meets

all its payment obligations, both external and
internal, without financial, operational or
reputational damage.
Sources of Liquidity Risk
Behavior of Market
Operational Failure
Insurance Risk
Market Price Movements
Credit Issues
Factors that Determine Liquidity Risk
Cash flow profile of the company
Firms business model
Product mix of the firm, including
on/off balance sheet activities.
Collateral given and received by the
firm.
Re-hypothecation
Time-horizon
Vulnerability to liquidity changes

Speed at which the firm can achieve

liquidity or consume it
Changes in business model or
strategies
Industry and regulatory norms.
Include significant business activities
Transparent, Decision-Marking Processes,
take into account normal and stressed
scenarios. Allocate the liquidity cost across
business/management lines.
Collateral Management Process
A firm with a good liquidity risk
management practices, actively
manages its collateral positions with
regard to currencies, jurisdictions and
legal frameworks. The firm must
monitor and manage the terms of
existing funding or security
arrangements (Warrants, Covenants,
Events of the Default, Negative
pledges, Cross default).
Liquidity risk management should
ensure that the firm has access to
diversified sources of funding in an
appropriate range of tenors. Ensuring
that alternative sources of funding are
available in case of institution-specific
or market-wide stress.
o DNS: Deferred net systems.
o RTGS: Modern payment system.
Liquidity Buffer refers to protection
against adverse change. The firm uses
liquidity buffer to withstand liquidity
stress or changes in liquidity during
stress testing.
The basic financial instruments are
fixed income, non-maturity
instruments, stocks, commodities and
credit risk contracts. The basic
instruments are combined to form
synthetic contracts, such as swaps,
forwards, futures, options, credit risk
derivatives and structured products.
Financial liquidity analysis and Time

Historical analysis
o Analytical framework which
uses past data to predict the
future occurrences
Static analysis
o Static analysis is the analysis of
existing trend and projecting it
into the future
Dynamic simulation
o Dynamic analysis takes into
account the changeability of
variables
Market liquidity risk is associated with the
changes in expected cash flows that can
arise from the following reasons:
Unexpected price movements
Higher bid-offer spreads
Market impact of trading
Revenues from the sale of assets may
be less than expected
Liquidity and Credit Risk
Credit risk refers to the counterpartys
inability to fulfill its contractual
obligations. All elements of credit
analysis should also be considered in
liquidity analysis.
Probabilities of default (PDs) should be
assigned to all counterparties of the
firm.
Two types of cash flows arise after
default: Exercising of credit
enhancements (ecc) and expected
recovery from the counterparty (ep).
Two unknown factors affect the
expected liquidity: The future time
period or interval of receiving the cash
flows eci and er . Asset-based credit
enhancements include financial
collaterals, physical collaterals and
closeout netting.
Double Default refers to a case where
the original counterparty and the
counterparty to credit enhancements
both default on their obligations.

In many cases, the counterpart y

behavior affects an institutions
liquidity. The five main types of
behavior that affect liquidity are
o Drawings- The cash in and
cash out are unknown to the
firm and are determined by the
counterparty.
o Prepayments
o Draw-Downs- A Behavior where
the borrower draws down the
loan facility gradually in
accordance with liquidity
o Selling- Sells assets due to
policies, market conditions and
funding liquidity
o Recovery rates- Exercising
credit enhancements. Good will
of the counterparties.
Insurers receive premiums from policy
holders
o Life Insurance Risks
Biometric Risks
Underwriting Risk,
covering all risks related
to human life conditions
Non-biometric Risks
Lapse risk- loss in value
of insurance liabilities
Expense risk- Variation of
expenses
Revision risk- Adverse
variation of a life
annuitys amount.
No-life insurance risks
Claims risk (more/large
claims are reported than
expected)
Incurred but not reported
claims
Reported time of claims
Severity of the events
Liquidity gap reports help to evaluate
and maintain the cash flows at a
sufficient level

Marginal liquidity gap shows the

expected, future net liquidity of
expected cash ins and cash
outs at each time bucket.
Cumulative liquidity gap sums
the marginal cash flows for the
preceding time buckets. The
cumulative report indicates the
duration of liquidity survival
without external funding report.
The cumulative report LaR {The
distribution of the minimum
survival period with a set
confidence level}
Residual. The remaining liquid
assets position at any point in
the future and the surplus or
default of liquid assets implied
by the expected cash flows.

SCAP
o The Supervisory Capital
Assessment Program allows
supervisors to measure how
much of an additional capital
buffer, if any, each institution
would need to establish to
ensure that it would have
sufficient capital if the economy
weakens more than expected.
o A banking organization holds
capital to offset potential
(unexpected) losses under
uncertainty
They were asked to
estimate their potential
losses on loans, securities
and trading positions as
well as PPNR and ALLL
under two alternative
macroeconomic
scenarios.
In practice, supervisors
expect all BHCs to have a
level and composition of

Other
o

Tier 1 capital well in

excess of the 4%
regulatory minimum.
Firms may choose to apply to
the US Treasury for Mandatory
Convertible Preferred (MCP)
under its Capital Assistance
Program (CAP) as a bridge to
private capital in the future.
Higher loss estimates do not
necessarily imply a need for
more capital to meet the SCAP
buffer. Scenarios that were
considered extreme or
innovative were often regarded
as implausible by the board and
senior management.
Considerations
Ex-post assessments lack
reliability and relevance
because they are based on
limited information and they are
not forward looking
Most markets have fatter tails
than normal, so the same
percentile break in the two
different distributions will have
more probability in the historical
distribution and less in the
parametric model
The VaR will decrease if the
puttable feature of a bond
reduces the VaR figure of the
portfolio of a long position.
Loss rates are calculated as
cumulative, two-year losses
divided by beginning-of-period
loan balances.
The VaR estimate should be
based on a 10 day interval at a
99% confidence level.
Each bank must meet, on a
daily basis, a capital

requirement expressed as the

higher of
Its previous days VaR
Average of daily VaR
preceding 60 days * max
(3, mf) + ex-post
performance (between 0
and 1)
Monte Carlo simulations falter
due to
Complexity of portfolio
Discontinuities or nonlinearity
Unavailability of closed
form analytical models.
VaR of a fixed income
instrument
MD* Interest Rate* Daily
Volatility* z-factor
Using Beta (from CAPM)
significantly eases the burden
for the estimation of risk. VaR=
z-factor * beta* volatility of
market*Value of position
When the volatility of the yield
for a bond increases, the VaR
for the bond increases and its
value stays the same.
An interest rate swap can be
modeled as a combo of a fixed
coupon bond and a floating rate
note.
A FRA is a combination of an
asset and a liability. So a long
position in a 3 by 6 FRA is
valued as the present value of a
3 month cash flow asset and the
present value of a 6-month cash
flow liability.
When the volatility of the yield
for a bond increases, the VaR
for the bond increases and its
value stays the same.
The 1st order approximation of
the VaR of option= VaR of the

underlying * delta. 2nd order

approximation= delta * VaR
(1/2)*(gamma)(Var*Var)
Basel II requires financial
institutions to compare their exante VaR to actual P & L. They
may differ because of the effect
of intraday trading, timing
differences in accounting
systems and incorrect
estimation of VaR parameters.
Normal mixtures, EVT, and the
t- distribution are all possible
solutions addressing the issue
of heavy tails in financial
returns.
For mean reversion:
VaR= (invnorm(percentile))*vol
atility*position- (expected
return).
Portfolio uncorrelated assets:
V(cA+ dB)= c^2 * V(A) + d^2
*V(B)
The square root of time:
Portfolio is static from day to
day. Asset returns are
independent and identically
distributed. Volatility is constant
over time. No serial correlation
in the forward projection
volatility.
The error of Monte Carlo is
inversely proportional to the
square root of sample
size/simulations. Its accuracy is
also dependent on Shape of
distribution and confidence
level.
Model error when VaR on a
normal distribution with static
mean and std dev?
Autocorrelation of squared

o
o

returns, clustering, and heavy

tails.
Conditional VaR expected
average losses above a given
VaR estimate.
Normal mixtures will always
have a kurtosis greater than a
normal distribution with the
same mean and variance.
VaR is sub-additive (P(A+B)<=
P(A)+P(B)) in cases where
correlation is less than one.
Component VaR is additive.
Principal Components:
Curvature component, tilt
component, trend component.
The factors to be applied to pc
are obtained from eigenvectors
of the correlation matrix. The PC
is used when considering a
large number of correlated
variables. Uncorrelated to each
other.
The economic capital required
to avoid insolvency is just the
asset VaR.
If returns display mean
reversion: Daily volatilities >
weekly volatility.
Total Value of Positions
(additive). Total MD= weighted
average of the MDs.
Historical stress testing
reenacts the events of this
history.
Monte Carlo and historical
simulation do not incorporate
mean reversion.
Stress testing identifies lowprobability losses beyond the
usual VaR measures.
RTGS are specialist funds
transfer systems where transfer
of money or securities takes
place form one bank to another

on a real time and on gross

basis.
Incremental EC contributions
assume that the EC should be
allocated exactly to the same
extent of the amount released
as in case when the business
unit is sold or added.
Funding liquidity risk is
associated with the inability of
the firm to fulfill its obligations
under normal and extreme
conditions.

Credit Risk
A credit risk manager reviews strategic credit positions, sets
credit limits, measures credit exposures, verifies whether all
significant risks are covered in credit reports, check for signals
from stress and scenario analysis at portfolio or global level,
identifies past or anticipated changes in general loss provisions,
verify whether all transactions are fully documented, and checks
whether credit protection is fully utilized.
Collateralized lending is based on haircuts. These haircuts reflect
collateral volatility and mismatch of each collateral type.
Government bond (5%), Corporate Bond (10%), Blue chip equity
(20%), Other Equity (50%).
Credit Managers prefer a dynamic collateral system, such as
value-at risk system, for the collateral portfolio. This system of
collateral lending is not only dynamic, but it also accounts for
correlations between the underlying risk factors.
A credit officer must carefully set limits for counterparty
exposures. Notional amount, expected loss and term-to-maturity.
Some of the challenges faced by the credit officer while
measuring credit exposure are full exposure coverage and
aggregation, globally consistent definition and usage of risk
factors and measures. Correct capture of credit derivative
exposure and correct treatment of wrong-way exposure.
A good credit report must include:
A list of largest individual counterparty exposures
Credit risk concentrations by sector/industry
Country specific exposures
Exposures by product category
Time evolution of credit exposures
Shift in risk parameters

A watchlist of transactions or counterparties requiring

special monitoring.
Stress testing and scenario analysis are mandatory under Pillar II
of the Basel Capital Accord for credit risk management.
According to Pillar II, banks are required to perform stress testing
to identify possible events or changes in market conditions that
could adversely impact their credit exposure.
Provisioning: Expected losses are priced directly into the product
while unexpected losses are covered by the risk capital.
Provisions recognize expected losses internally and avoid the
possibility that such losses would harm future profit & loss.
Provisions can be made at two levels: General loss provisions:
Made at portfolio level. Individual loss provisions: Made at
individual exposure level, generally for large transactions.
Documentation plays an important role in credit risk
management. A standardized credit document helps to resolve
problems with formulation and interpretation of contract details.
A credit officer must make sure that break clauses and rating
triggers are fully recognized. Rating triggers are provisions in an
agreement that initiates a specific action in the event of a
change in a firms credit rating.
Credit Protection. A credit officer has to take measure to protect
the bank from counterparty default with C-Deriv and
Securitization. Review of credit strategy, models, credit process,
stress testing.
Default Risk is the risk that arises due to counterpartys inability
to meet its obligations. Instruments that give rise to default risk
for any credit or counterparty. Loans, bonds or credit notes, Cash
payments, goods or services owed, Long-term supply contracts,
Derivatives and other off-balance sheet contracts.
Credit loss
o Credit loss can be defined as the potential amount
of loss if the counterparty defaults. The expected
amount of credit exposure could be lost from
default:
Probability of Default* Exposure of Default
(The amount owed at default should the
default occur) *Loss Given Default (1recovery rate).
Expected Loss on a Portfolio: Sum of the
product of the PDs, EADs and LGDs for every
ith facility.
o The unexpected losses (UL) are a measure of
portfolio risk. It characterizes the losses that can

occur under unfavorable conditions and have a

large impact on the institutions portfolio.
o The unexpected credit loss represents the loss that
will not be exceeded at some level of confidence. It
is the deviation from the expected loss. Unexpected
loss is usually defined as a quantile of the
distribution.
Suppose the 99% quantile of the portfolio is
given by D-99%, then the unexpected loss of
the portfolio at 99% is defined as the
difference between the 99% quantile and the
expected loss of the portfolio:
UL= D-99%- EL
Unexpected losses are non-additive.
o The credit portfolio loss distribution is not
symmetrical, highly skewed, etc.
o Seniority class
Senior secured
Senior Unsecured
Senior subordinated
Subordinated
Junior Subordinated
Inability to pay ones debts is called
insolvency
o Wide uncertainty is the main characteristic of
recovery rates. Beta distribution can be used to
capture this uncertainty.
Credit Exposure
o Credit Exposure to a counterparty is the amount
that could be lost when the counterparty defaults
which is equal to the Replacement cost of the
counterpartys obligation.
o Sources
Loans, bonds, credit notes
Cash payments, goods or services owed by
debtor
Long-term supply contracts
Derivatives and other off-balance sheet
contracts.
Direct or fixed exposures
Commitments- Lines of credit
Variable exposures- OTC transactions in
derivatives
o Current Exposure

Current Exposure is the exposure to a loss

from a counter party default as of the
measurement date. For a derivatives
contract, the current exposure is the
replacement cost of a defaulted in-themoney contract. Current exposure= current
value of the potential loss. Exposure based
on a transactions mark-to market (MTM)
value. Negative (or zero) mark-to market
value= 0. Positive mark to market= Current
exposure= market value. For swaps: V_t=
V_t (fixed rate)-V_t (floating rate)
Mark-to Market exposure
These contracts can be valuable if the price
of the contract is favorable compared to the
market price. This exposes the party to the
risk of a default by the counterparty, in
which case the contract needs to be replaced
at the new market rates. This is called the
mark-to market risk.
There are two types of contracts for future
delivery of goods or services:
Contract to sell goods at a set price
Mark to Market exposure: (Contracted selling
price-market price) *Quantity
Contract for delivery on a set date
Mark to Market exposure: (Contracted selling
price-Forward Price)*Quantity
delivered*Discount factor.
Potential Future exposure
Potential future exposure is the estimated
exposure to loss due to the risk that potential
changes in value (or market prices) over
time could increase credit exposure.
Expected Measure
Measures the amount, on average,
that will be lost if a default transaction
An expected exposure is calculated at
different points in the future over the
life of the transaction
Worst-Case Measure
Maximum credit exposure
o 95-th percentile of the
distribution of value of
outstanding transactions at that

time. Maximum exposure

determines how much credit to
allocate for transactions against
counterparty.
Peak exposure
o Peak exposure is the maximum
of all maximum exposures over
a specified time interval.
o Non-payment Exposure
Non-payment exposure is the total amount at
risk due to an obligors default (nonpayment). Depending on when and for which
time period it is computed, we call it either
current or potential credit exposure. This
exposure is equal to the principal amount
receivable + any accrued interest.
Pre-Settlement and Settlement Risk
o Settlement risk occurs when the settlement in a
transfer system does not take place as expected.
This happens when one party defaults on its
obligations.
Comprises both credit and liquidity risks
Final settlement of the transaction.
o Settlement risk occurs during the period of
irrevocable and uncertain status. The amount at
risk equals the full amount of currency purchased
and lasts from the time that a payment instruction
(for the currency solo) can no longer be cancelled
unilaterally until the time the currency purchased is
received with finality. To manage settlement risk,
RTGS, bilateral netting and multilateral settlements.
Replacement risk is a consequence of settlement
risk. Replacement cost that an institution would
incur if counterparty completely defaulted on its
obligations.
o Herstatt risk is foreign exchange settlement or
cross-country settlement risk.
o The current Mark-to-Market (MTM) is the amount of
risk if the counterparty defaults today. The potential
future MTM component is the largest amount which
is potentially at risk if market rates move in a
favorable direction and the counterparty defaults
under these circumstances.
Credit Risk of Derivatives
o Interest Rate Swap

The risk of an interest rate swap is that the

counterparty will default on the payment
leaving the non-defaulting party with the
exposure the swap was intended to hedge.
Credit risk on a swap due to two events
happening simultaneously.
The swap is in-the-money.
The counterparty defaults.
In-the-Money= Receive floating with a fall in
interest rates.
Default risk depends on the probability of
default and on the interest rate risk.
Interest rate risk
Current Exposure (Replacement Cost)
Potential Exposure (Loss suffered
during life of transaction).
NPV (original fixed interest)- NPV
(replacement swap fixed interest).

NPV (i) = PMT *

1(1+i)n
i

i= R/ (f*100) where R is interest rate

and f is frequency of payment.
Currency Swaps
The major risks posed by currency swaps are
interest rate risk and currency risk and also
credit risk. Credit risk in currency swaps is
more substantial compared to interest rate
swaps. This is because while interest-rate
swaps involve the risk of default to interest
payments only, for currency swaps, credit
and settlement risks also extend to the
payment or principal.
Fixed-to Fixed
o All three variables impact MTM
value.
Fixed to Floating
o Pay 8% U.S fixed and receive
U.K floating. In this case, only
two variables matter.
U.S Swap Rate; the swap
dealer has exposure if it
is greater than 8%. U.K
pound sterling /U.S dollar
exchange rate; the swap

FRAs
The credit risk associated with a FRA differs
from that of a debt instrument, because a
FRA is not a funding transaction and
therefore involves no exchange of principal.
No initial credit risk. Potential credit risk is
bilateral; a party to a FRA is exposed to
credit risk when the value of the agreement
becomes positive to him or her, and the
value of a FRA can change, so that it will gain
value to the party.
Potential credit risk exposure is a small
fraction of the notional amount of the
agreement. Credit risk exposure is
determined by the value of the FRA.
Payment= (N * (R-F) *alpha)/
(1+R)*alpha
o Credit risk for the buyer/seller
If the bank buys a European style option,
there is a risk that the counterparty will not
pay if the option is exercised in the money. In
addition, the bank does not know exactly
what the value of the option will be if it is
exercised in the money. In such cases, the
credit risk can only be calculated as a
probability.
Credit risk for the seller: If the buyer has paid
the premium in full at the start of the
contract, there is no counterparty credit risk.
However, if the premium is due and the
option is in the money (for the seller), the
seller faces counterparty credit risk.
Mitigation of Exposures
o Counterparties in OTC derivative transactions
should minimize their credit risk exposure.
Exposures can be significantly reduced with wello

dealer has exposure if the

pound appreciates.
Floating to Floating
o Pay U.S floating rate and
receive U.K floating rate
In this case, only one
variable impacts the
MTM: exchange rate.

designed agreements without need for economic

capital and without large additional costs to the
counterparties.
In the following screens, we discuss three exposure
mitigation techniques: Netting, Collateral and
Guarantees.
Netting
A netting agreement is a contract between
trading partners to offset their obligations.
Under such agreement, each party agrees to
set off the amounts it owes against the
amounts owed to it.
In doing so it reduces the number of
payment messages, it reduces both
counterparty credit risk and liquidity risk, it
reduces the need for intra-day liquidity or
credit. It also benefits from Basel Capital
Agreement.
The net exposure with netting is given by:
summation of Max (V, 0) for each i. Without a
netting agreement, the gross exposure is the
sum of all positive-value contracts.
Gross exposure is always greater than or
equal to the exposure under the netting
agreement. The benefit form netting
depends on the number of contracts N and
the extent to which contract values correlate.
The larger the N and the lower the
correlation, the greater the benefit from
netting.
Netting agreements can be classified as into:
Bilateral agreements (two counterparties
agree to a net with one another), and
multilateral agreements (more than two
counterparties). These can be further
categorized as
Payment netting: Reduces settlement
risk. If counterparties are to exchange
multiple cash flows during a given
day, they can agree to net those cash
flows to one payment per currency.
Such payment nettings reduce
settlement risk, as well as streamlining
processing.

Netting by Novation: If parties enter a

transaction that gives rise to an
obligation for the same date as an
existing obligation, then the two
obligations are cancelled and
simultaneously replaced with a new
obligation for the net amount.
o In the FX market we have
matched pair novation netting
(Same Pair of currencies).
Comprehensive novation
netting (All Pairs of Currencies).
Close-out netting: Close-out netting is
an arrangement to settle all
contracted but not yet due liabilities to
and claims on an institution by one
single payment, immediately upon the
occurrence of one of a list of defined
events.
Collateralization
Involves transfer of financial assets between
two parties in order to reduce the credit risk
of transactions between them. The
derivatives contracts are revalued ( or
market-to market) on a daily basis, and the
party to the trade must post collateral to the
exchange clearing house if the value of the
contract moves unfavorably. This mitigates
the credit risk. 3
Apart from collateral, other credit
enhancement techniques that are available
to market practitioners are netting. Third
party guarantees, Special Purpose Vehicle
(SPV) and cash settlement provisions.
Any collateral that is eligible for posting is, as
a result of market movements, liable to
decrease in value relative to the exposure it
is intended to secure. To counter this, dealers
typically assign less than the full face value
to that collateral. The amount by which the
value assigned to the collateral is less than
the full face value is termed as the haircut,
usually expressed in percentage terms of the
face value.

Guarantees
An explicitly documented obligation assumed
by the guarantor; for the proportion of the
exposure covered, the guarantor covers all
payments the underlying obligor is expected
to make under the loan exposure.
Limits (Credit Limits), Termination rights,
credit puts, Third party guarantees and CDev.
The expected credit exposure is the
expected value of the asset replacement
value.
Credit and Credit Migration
o A credit rating is an opinion on the general
creditworthiness of an obligor, or the
creditworthiness of an obligor with respect to a
particular debt security or other financial
obligation, based on relevant risk factors. Credit
rating agencies are financial service firms that
assess the credit risk inherent in a specific
security. Agencies can be classified into three
categories: National, Regional and Global. National
agencies are especially evident in Sweden.
o The four major US rating agencies are Moodys
Investor Services, S & P, Duff and Phelps Credit
Rating Co. and Fitch IBCA. Investment grade is a
direct reference to the quality of a companys
credit. In order to be considered an investment
grade issue, Standard and Poors or Moodys must
rate the company at BBB or higher. Anything
below BBB rating is considered speculative grade,
and the probability of the company failing to repay
its issued debt is deemed relatively high.
Standard & Poor: Short Term: A-1+, A-1, A-2,
A-3, B, C, D. Long Term: AAA, AA+, AA, AA-,
o

An investor has borrowed an amount

of 5000 from the broker. The investor
deposits collateral worth 5000 to his
broker. His broker asks for additional
collateral worth 1000. What haircut
rate is he applying to the collateral?
o (5000+1000)(1-haircut rate)=
5000

A+, A, A- , BBB+, BBB, BBB-, BB+, BB, BB-,

B+, B, B-, CCC, CC, C, D.
Moodys: Short Term: P-1, P-2, P-3, And Not
Prime. Long Term: Aaa, Aa1, Aa2, Aa3, A1,
A2, A3, Baa1, Baa2, Baa3, Ba1, Ba2, Ba3, B1,
B2, B3, Caa, Ca, C.
Blue for Investment Grade, Red for
Speculative Grade.
A sovereign credit rating is an assessment of the
governments ability and willingness to service is
debt in full and on time. Standard & Poors
appraisal of each sovereigns overall
creditworthiness is both quantitative and
qualitative. As the default frequency of sovereign
local currency debt differs significantly from that of
sovereign foreign currency debt, the two are
analyzed separately.
Country risk refers to the risk that a country wont
be able to honor is financial commitments. Country
risk applies to stocks, bonds, mutual funds, options
and futures that are issued within a particular
country. This type of risk is most often seen in
emerging markets or countries that have a severe
budget deficit.
Internal credit ratings are becoming increasingly
important in credit risk management at large
banks. The specifics of internal rating system
architecture and operation differ substantially
across banks.
In general, internal ratings systems differ on
following attributes.
Loss definition
Grades
Use of system
Basis of grading
Point-in-time
Through-the Cycle
The credit risk of a loan or other exposure over a
given period in values:
Probability of Default. Lost Given default
(fraction of the loans value that is likely to
be lost in the event of default).
The product of PD and LGD is the Expected
Loss (EL). It represents an estimate of the
average percentage loss rate over time on a

group of loans all having the given expected

loss.
Depending on the definition of loss, there are two
types of rating system implemented by bans:
One dimensional rating systems.
Two dimensional rating systems.
Administrative Grades
Regulatory problem asset categories are
shown in the following table;
Special Mention (OAEM)
o Have potential weaknesses that
deserve managements close
attention. If left uncorrected,
these potential weaknesses
may, at some future date, result
in the deterioration of the
repayment prospects for the
credit. No recommended
reserve.
Substandard
o Inadequately protected by
current worth/paying capacity of
obligor or collateral. Welldefined weaknesses jeopardize
liquidation of the debt. 15%
recommended specific reserve.
Doubtful
o All weaknesses inherent in
substandard, and
collection/liquidation in full, on
basis of currently existing
conditions, is highly
questionable. 50%
recommended specific reserve.
Loss
o Uncollectible and of such little
value that continuance as an
asset is not warranted. 100%
recommended specific reserve.
Banks base their ratings on criteria that define each
grade. Risk factors include borrowers financial
condition, size, industry, Position within the
industry, Reliability of financial statements, Quality
of management, and Elements of the transaction
structure.

The focus of financial statement analysis is on the

borrowers debt service capacity, taking account of
its free costs flow, the liquidity of its balance sheet,
and the firms access to sources of finance other
than the bank. The characteristics of the borrowers
industry (such as cyclicality, general volatility and
trends in cash flow and profitability) are often
considered to give context for financial statement
analysis. Other factors considered are quality of
financial information, borrowers management, and
country of domicile and structure of transaction.
Internal Risk Grades
o Banks use internal ratings in two broad ratings of
activity. Analysis and reporting, and Administration.
Analysis and Reporting
Reporting of risk exposures to the
senior management and the board of
directors.
Loan loss reserving
Profitability measurement
Economic capital allocation
Product pricing
Employee compensation
Administration
Loan monitoring
Regulatory compliance
Credit culture maintenance.
o At most banks, ratings are produced for all
commercial or institutional loans. As a part of preapproval process, an initial grade is proposed for
the credit. A staff member who is involved in the
credit approval proposes the initial grade. This
initial grading is based on the analysis of the
borrower and the credit and normally reflects the
expected loss from the credit.
Internal Rating Based Approach
o Under this approach, banks use internal
assessment of their counterparties and exposures
subject to regulatory standards. Banks are required
to categorize banking-back exposures into six
broad asset classes. For each of the first four
classes, there is a specified set of risk components,
risk weights and minimum requirements for
eligibility.
o

The components, PD, LGD, EAD, and M, are the

basic inputs under the IRB approach to credit risk
capital requirement evaluation. A banks credit risk
capital requirements also depend on the
concentration of banks exposures to
borrowers/group for borrowers. Granularity, or lack
of it, is a material drive of credit risk.
The IRB approach is further divided into Foundation
approach and Advanced approach. The
foundational approach, banks estimated the PD and
regulators supply other inputs. In the advanced
approach, banks estimate the PD, LGD, and EAD.
A corporate exposure is generally defined as a debt
obligation of a corporation, partnership, or
proprietorship. Banks own exposures of PD must be
greater of the one-year PD associated with the
internal borrower grade to which that exposure is
assigned, and 3 basis points (i.e 0.03%). Under the
Foundation approach; the PD of the guarantor (if
rated A or higher) substitutes for the PD of the
borrower.
Under the Advanced approach, banks use their
internal assessment as the degree of risk transfer.
A bank must estimate the Loss Given Default (LGD)
for each corporate exposure. This is a measure of
the expected average loss that the bank will
experience percent of exposures should its
counterparty default.
A risk-weighted asset is the risk weight of a
transaction multiplied by a measure of exposure for
that transaction. Total Risk Weighted Assets (RWA)
is the sum of individual RWAs across all
transactions. Calculation of total RWA for non-retail
exposures=< 12.50*LGD (See notebook for more
detail)
A corporate exposures risk weight under the
Advanced approach, RWC, can be expressed as
function of PD, LGD, and the effective maturity.
The definition of retail exposure is based on a
number of criteria, which seek to capture
homogeneous portfolios comprising a large number
of small, low value loans with a consumer/business
fees, and where the incremental risk of any single
exposure is small.

All exposures that are treated as sovereigns under

the Standardized Approach are also treated as
sovereigns under the IRB Approach. This includes
sovereigns, non-central government public sector
entities (PSEs) that are treated as sovereigns under
the standardized Approach, and MDBs that meet
the criteria for a 0% risk weighting under the
Standardized Approach.
o In credit portfolio risk modeling, granularity refers
to the number of the exposures in the portfolio. The
higher the granularity, the more positions are in a
credit portfolio, providing a higher degree of size
diversification, which in turn reduces concentration
risk.
o In this case the company can have advantage of
better rating of other countries. If the company has
significant operations outside of its home country.
Countries cannot be forced to bankruptcy. There is
no enforcement mechanism for payment to
creditors such as for private companies. Recent
history has shown that a country can simply decide
to renege on its debt.
Portfolio Models of Credit Loss
o The information obtained from the tables can be
used to estimate default probability for a given
rating class; higher ratings are typically associated
with lower default rates. For a given initial credit
rating, Default risk increases with the horizon.
o Cumulative default rates measure the total
frequency of default at any time between the
starting date and year T. Marginal default rates give
the frequency of default during the period (t,T) e.g.
over one year. The cumulative probability of
defaulting over two years.
o

Let, m (t+ R (t) ) the number of issuers rated R at

the end of year t that default in year T= t+N.

N(t+ R (t) ) be the number of issuers rated R at

the end of year t that have not defaulted by the
beginning of year t+N.

Then the marginal default rate during year T is

given by the ratio of the first equation to the
second.
Survival Rate:
N

o
o
o

1dj (R)
j=1

= Sn(R)

The marginal default rate can be derived from the

cumulative default rate tables. If the annual default
rate is d, the monthly default rate is derived from
the formula:
(1-dm)frequency of payment= (1-d)
Marginal default rate from start to year T is:
KN(R)= Sn-1 (R) * dN (R)
Cumulative default rate is:
CN(R)= K1 (R)+ +KN(R)= 1-SN(R)
Average default rate is:
N

i=1

= 1-(1-d)N

The computation of default rates can be simplified

by the use of ratings migrations, described by
transition. The transition matrix gives the
probability of moving from one rating to another
over a given period). Markov Process. (Check
notebook for more details).
o In measuring credit risk, the calculation of a
measure of the dispersion of credit risk requires
consideration of the dependencies between the
factors determining credit-related losses, such as
correlations among defaults on rating migrations,
2GDs and exposures, both from the same borrower
and among different borrowers. There are two
approaches for handling default/rating migrations
correlations.
Structural approach
Correlations by the joint movements of
asset prices.
Reduced-Form Approach
Reduced-form models explain
correlations by assuming a particular
functional relationship between
default and background factors.
Credit VaR
o

CN= 1-

1d i

Concentration risk refers to additional portfolio risk

resulting from increased exposure to one obligor or
groups of related obligors.
o The decision to take on even higher exposure to an
obligor will meet even higher Marginal Risk.
o Credit VaR is a function of the credit loss
distribution over a given time horizon and the
confidence level. It is measured as the difference
between the ECL and the Worst Credit Loss (WCL),
ie a quantile of the loss distribution taken at some
confidence level c. CVar= WCL-ECL (Check
notebook for more details)
Altmans Z score
o Z-score is a statistical measure that quantifies the
distance (measured in standard deviations)
between a data point and the mean of a data set.
In a more financial sense, Z-score is the output
from a credit-strength test that gauges the
likelihood of bankruptcy. A z-score of 0 is equal to a
50% probability of bankruptcy.
o Variables that comprise the Z-score for public and
private companies:
X1= Working Capital/Total Assets
X2= Retained Earnings/ Total Assets
X3= (Earnings Before Taxes+ Interest)/Assets
X4= Market Value of Equity/ Total Liabilities
X5= Net sales/ Total Assets
o A healthy public company has Z> 2.99. Gray zone
1.81 < Z< 2.99. Unhealthy Z< 1.81. Private
Company z>2.60, 1<z<2.59. z<1.1.
Merton and KMV Models
o JP Morgans CreditMetrics measures credit risk in a
portfolio context using default probabilities,
recovery rates, credit migration likelihoods and
correlations for their dataset. The output is
economic capital, return distribution and loss
percentiles.
o CSFBs CreditRisk+ is based on an actuarial
approach to modeling credit default risk. Default
rates, Default rate volatility, Recovery rates and
credit exposures. Economic capital, loss distribution
and loss percentiles are its outputs.
o KMVs Portfolio Manager produces mark-to-model
prices for credit assets and indicates capital levels
and marginal risk contributions using either
o

analytical approximation or Monte Carlo simulation.

Economic Capital, RARPC, Sharpe Ratio, Mis-pricing,
Optimization benefits, Return distribution are its
outputs. The KMV model assumes that credit risk is
driven by the dynamics of the asset value of the
issuer.
o Mckinsey & Cos CreditPortfolioView takes into
account the current macroeconomic environment.
Instead of using historical default rate averages,
CPV uses default probabilities and conditional on
the current state of the economy.
o Top-down models group credit risks using single
statistics. They aggregate many sources of risk
viewed as homogeneous into an overall portfolio
risk, without going into the detail of individual
transactions. Retail portfolios.
o Bottom-up models account for features of each
asset/credit. This approach attempts to measure
credit risk at the level of each loan based on an
explicit evaluation of the creditworthiness of the
borrower.
o Merton (1974) noted the formal equivalence, ie,
when a bank makes a loan, its payoff is equivalent
to that of a put option on the assets of the
borrower. (See the notebook for more details).
Credit Risk Capital Calculation
o Economic capital (EC) is the aggregate amount of
capital required as a cushion for a companys
unexpected losses due to credit, market, and
operational risk. The economic credit capital (ECC)
for banks provides backup against credit risk. It is a
buffer against the risks associated with obligor
credit events, such as default, credit downgrade,
and credit spread changes.
o Generally, a one-year horizon is used for credit VaR
measurement. Some for the reasons for the oneyear horizon. (One-year period is consistent with a
complete accounting cycle).
o Credit Losses
Default-only credit loss (PD, LGD, EAD)
Mark-to market credit loss
o A credit portfolio model aims at estimating the
economic capital that would limit the probability of
insolvency over a given time horizon. The achieve
this, the firm should select a quantile (confidence

level) of the credit loss distribution that would make

the shareholders highly confident that the losses
will not exceed this limit.
Economic capital should be adequate to cover for
unexpected losses (UL); the expected losses (EL)
are covered by capital reserves. In this case, the
credit VaR
Credit VaR (L)= Q(L)- EL (The quantile of the
alpha% quantile of the portfolio less
distribution)
ECC aggregation. A firm acquires credit risks
through various, activities such as retail banking,
commercial lending, bonds and derivatives. Given
the diverse nature of these activities, the firm is
likely to have different methodologies for various
types of credit risk.
Sum of stand-alone capital
Under this methodology, the credit risk
capital requirement is simply the sum of
stand-alone capital for each business linear
portfolio.
Ad hoc cross-business correlation
The firm aggregates stand-alone capital
using analytical models, and simple crossbusiness (asset) correlation estimates.
Full enterprise (credit portfolio modeling)
Full enterprise credit portfolio modeling is
done using semi-analytical methods, or fullblown Monte Carlo simulation.
The Basel I accord called for a minimum overall
risk-weighted capital of 8%, with at least 50% in
the form of Tier-I capital. To compute the capital
requirements, a bank must first determine the
dollar value of assets in the five risk categories. The
minimum capital requirement is obtained by
multiplying total risk-weighted assets by the
minimum capital adequacy ratio (8%).
Basel II suggests three different approaches
as for measurement of credit risk capital.
Standardized approach, Foundation IRB
approach, Advanced IRB approach.
Claims on sovereigns and their central banks
are risk-weighted as follows
AAA to AA- 0%
A+ to A- 20%

o
o

BBB+ to BB- 50%

BB+ to B- 100%
Below B- 150%
Unrated- 1000%
ECA risk scores- Risk weight
1 0%
2 20%
350%
4 to 6 100%
7 150 %
o An exposure worth 75 million to
a central bank has a rating of
BBB+. What is the minimum
capital charge required:
Exposure * 50% * 8% capital.
Claims on securities may be treated as
claims on banks, provided these firms care
subject to supervisory and regulatory
arrangements comparable to those under
the Basel II framework.
Claims may be considered as retail for
regulatory retail portfolio if they meet the
following criteria:
Orientation criterion
Product criterion
Granularity criterion
Low value of individual exposures
The unsecured portion of any loan that is
past due for more than 90 days is risk-weighted net of specific provisions.
< 20% of outstanding loan amount
>= 20% of outstanding loan amount
>= 50% of the outstanding loan
amount.
The internal ratings-based (IRB) approach is one of
the cornerstones of the Basel II. Under this
approach, banks rely on their own internal
estimates of risk components in determining the
capital requirement for a given exposure.
The risk components are PD, EGD, EAD, M.
Under the IRB approach, banks categorize banking
book exposures into as shown below:
Corporate: Project finance, Object finance,
Commodities finance, Income-producing real
estate, High-volatility commercial real estate.

Sovereign
Bank
Retail: Residential mortgage exposures.
Other retail exposures.
Equity
Specialized Lending
Project Finance (PF)
Object Finance (dF)
Commodities Finance (CF)
Income Producing Real Estate (IPRE)
High volatility Commercial Real Estate
(HVCRE)
Securitization is a risk management technique by
which ownership and low risks associated with the
credit exposures are transferred to other parties.
Securitization is used to improve risk diversification
and enhance financial stability.
Traditional securitization
Synthetic securitization (tranches)
VaR is subadditive for normal distributions.
Allocation of economic capital to a portfolio is
required to carry out certain functions, such as
Business planning and management decision
support
Risk-based compensation and performance
measurement.
Profitability assessment, limits and pricing.
Framing optimal risk-return portfolios and
strategies.
Considerations
Company A issues bonds with a face value of 100
million, sold at issuance at 98 dollars. Bank B holds
10 million in face of these bonds acquired at a price
of 70. What is Bank Bs exposure to the debt issued
by Company A? Bank Bs exposure is measured by
the price paid for the bonds, which in this case is 7
million (10 million *.70).
Company A issues bonds with a face value of
100m, sold 98. Bank B holds 10 million face of
these bonds acquired at a price of 70. Company A
then defaults, and the recovery is expected to be
30%. What is Bank Bs loss? The bank paid 7
million for the bonds, and expected recovery is 3
million (30% * 10 million face). Therefore Bank Bs
loss is 4 million (7million-3million).

o
o

Other
o

o
o

o
o

o
o

The unexpected loss for a credit portfolio at a given

VaR estimate is defined as VaR- Expected Loss.
Unexpected losses for individual loans in a portfolio
will always sum to greater than the total
unexpected loss for a portfolio sans correlation that
would make them default together.
Expected losses are charged against the P&L of the
unit holding the exposure. The notional or the face
value of the defaulted debt is the basis for a claim
in bankruptcy court.
Random recovery rate in respect of credit risk can
be modeled using the beta distribution.
Concentration risk is a credit portfolio arises due to
a high degree of correlation between the default
probabilities of the credit securities in the portfolio.
The legal claim for OTC derivatives is the current
replacement value of the contract.
Recovery rate assumptions are difficult to make
given the effect of the business cycle, nature of the
industry and multiple other factors difficult to
model. The standard deviation of observed
recovery rates is generally very high, making any
estimate likely to differ significantly from realized
recovery rates.
Credit risk report
Exposure by country
Largest exposures by counterparty
Exposures by industry
In estimating credit exposure for a line of credit, it
us usual to consider a fixed fraction of the line of
credit to be the exposure at default even though
the currently drawn amount is quite different from
such a fraction.
Pre-settlement risk is the risk that one of the
parties to a contract might default prior to the
maturity date or expiry of the contract. Presettlement risk can be partly mitigated by providing
or early settlement in the agreements between the
counterparties. The current exposure from an OTC
derivatives contacts equivalent to its current
replacement value. Loan equivalent exposures are
calculated even for exposures that are not loans as
a practical matter for calculating credit risk
exposures.
To reduce credit exposures to a counterparty

o
o

o
o

o
o

Netting arrangements
Collateral agreements
Credit default swaps
The risk that a counterparty fails to deliver its
obligation is upon settlement while having received
the leg owed to it is called settlement risk.
The bullet bond will always have a higher exposure
at any time during its life when compared to an
equivalent amortizing loan.
Credit exposure for derivatives is measured wing
forward looking exposure profile of the derivative.
A derivative contract has a negative current
replacement value. The credit exposure will be a
given quintile of the expected distribution of the
value of the derivatives contract in the future.
For a 10 year interest rate swap, what would be the
worst time for a counterparty to default the worst
time for the counterparty to default is somewhere
between inception and maturity- in fact the range
of possible outcomes for the contract increases
with the passage of time, and we should find the
worst time to default to be a later date.
For a FX forward contract, what would be the worst
time for a counterparty to default (in terms, of the
maximum likely credit exposure) at maturity.
A rating downgrade is not an event (credit)
All transactions are netted against each other. All
transactions are immediately closed out upon the
occurrence of a credit event for either of the
counterparties. The net amount due is immediately
receivable or payable.
Escrow arrangements using a central clearinghouse
can be used to reduce settlement risks.
Collateral, limits to avoid credit exposure
concentrations, termination rights based upon
credit ratings, third party guarantees and credit
derivatives are all tools or instruments that
financial institutions use to manage their credit
risk.
For a given notional amount, which of the following
carries the greatest credit exposure? A one year
certificate of deposit.
Commercial paper has greater credit risk as the
entire notional is outstanding. On the forward
contract, only the replacement value of the

contract, which normally would be a mere fraction

of the notional, would be at risk.
In a bankruptcy equity ranks last. Preferred equity
is one level above equity. Senior debt gets paid at
first compared to junior debt, and secured debt is
paid out first to the extent of the asset securing it.
Accounts payable and other short term liabilities
are treated like unsecured creditors. Debtor-inpossession (DIP) financing higher than any other
asset as it is financing secured after the bankruptcy
to continue the business.
If a borrower has a default probability of 12% over
one year, what is the probability of default over a
month? (1-dm )12 = (1-d)
A zero coupon corporate bond maturing in a year
has a probability of default at 5% and yields 12%.
The recovery rate is zero. What is the risk free rate?
(Cash flows in the event of default, probability of
default)+ (cash flows without default) * (1-p-o-d)
5%*0 +(105%)*(1+12%)= (1+RS):: RS= 64%
A corporate bond in 1 year yields 8.5% per year,
while a similar treasury bond yields 4%. What is the
probability of default for the corporate bond
assuming the recovery rate is zero?
The probability of default would make the
future cash flows from both the bonds
identical: If p be the probability of default,
the cash flows from the risk corporate bond
would be (cash flows in the event of default *
probability of default) + Cash flows without
default *( 1-probability of default)
P*0 + (1-p) *(1+8.5%)= (1-p)*1.085
1.04= (1-p)*1.085
A corporate bond has a cumulative probability of
default equal to 20% in the first year, and 45% in
the second year. What is the monthly marginal
probability of default for the bond in the second
year, conditional on there being no default in the
first year?
CN= 1-(1-p1)(1-p2).(1-pN)
Marginal probability of default for year 2 by
solving the equation [1-(1-20%)(1-P2)= 45%]
. Solving we get the marginal probability of

o
o
o
o
o

o
o

default during year 2 as 31.25%. 1-31.25%=

(1-M1)12
If the cumulative default probabilities of default for
years 1 and 2 for a portfolio of credit risky assets
are 5% and 15% respectively, what is the marginal
probability of default in year 2 alone?
CN= 1-(1-p1)(1-p2).(1-pn)
15%= [1-(1-5%)(1-p)]; p
If the marginal probabilities of default for a
corporate bond for years 1, 2 and 3 are 2%, 3%,
and 4% respectively, what is the cumulative
probability of default at the end of year 3?
CN= 1-(1-p1)(1-p2)(1-pn)
CN= 1-(1-2%)(1-3%)(1-4%)
CN= 8.74%
If the annual default hazard rate for a borrower is
10% what is the probability that there is no default
at the end of 5 years? A default hazard rate is the
rate of default in a continuous time setting. The
question is asking for probability of survival at the
end of 5 years? e^(-lambda*t)
Hazard Rate= Spread/(1-Recovery Rate)
If odds are H, then p= H/(1+H)
A cumulative accuracy plot measures rating
accuracy.
Rating agencies target both accuracy and stability
when they assign ratings.
Transition matrices are used for building
distributions of the value of credit portfolios, and
are the realized frequencies of migration form one
credit rating to another over a period.
Rating agencies generally provide transition
probability matrices for a given period of time, say
a year. The risk analyst may need to convert these
into matrices for say 6 months, 2 year or whatever
time horizon he is interested in. Simplifying
assumptions that allow him to do so include time
invariance and the Markov property.
An assumption regarding the absence of ratings
momentum is referred to as Markov property.
dS/S= mu dt + rho dz
To get the price itself, we include the current
price to the change in price.

o
o
o

o
o

The transition matrix for any time period as p^n,

where P is the given transition matrix for one
period . N is time periods.
If P be the transition matrix for 1 year, in 4 months?
M^n= P; M^3= P
A numerical computation based upon accounting
ratios.
Altmans z-score:
Working capital to tail assets
Retained earnings to total assets
EBIT to total assets, Market cap to debt
Sales to total assets
A high score under the probit and logit models
indicates a higher default risk, while under Altmans
methodology it indicates a lower default risk.
For a corporate issuer, which of the following can
be used to calculate market implied default
probabilities? CDS spreads and Bond prices.
The CDS rate on a default table bond is
approximately by which of the following
expressions: LGD * Default hazard rate.
Both recovery rate and probabilities of default are
related to the business cycle and more in opposite
directions to each other. Corporate bond spreads
are affected by both the risk of default and the
liquidity of the particular issue.
Hazard rate *Loss given default= CDS quote
Hazard rate * (1-recovery rate)= CDS quote
The spread premium puzzle refers to observed
default rates being much less than implies default
rates, leading to lower credit bonds being relatively
cheap when compared to their actual default
probabilities.
The Altman credit risks core considers a
combination of accounting measures and market
values.
A portfolio as two loans, A and B each worth 1
million. The probability of default of loan A is 10%
and that of loan B is 15%. The probability of both
loans defaulting together is 1%. Calculate the
expected loss on the portfolio:
Loan B
defaults

Loan A defaults
1%

Loan A survives
14%

Loan B
survives

9%

10%
90%
Therefore the expected losses on the
portfolio are (1 M * 09%) + (1M * 14%)
+(2M* 1%)+ (0% *76%)= 250000
If two bonds with identical credit ratings, coupon
and maturity but from different issuers trade at
different spreads to treasury rates, which of the
following is a possible explanation. The bods differ
in liquidity. Events have happened that have
changed in investor perceptions but these
If A and B are two debt securities:

P(A defaults

B defaults) = (Default

correlation of A & B) *

76%

P ( B )(1P ( B ) )

1P ( A )
P ( A )

What ensures that firms are not able to selectively

default on some obligations with that being
considered in default on the others? Cross-default
clauses in debt covenants.
When considering a request for a loan from a retail
customer, which of the following factors is relevant
for a bank to consider: The contribution this new
loan would bring to total portfolio risk. The credit
worthiness of the retail customer and the other
retail loans in its portfolio.
If E denotes the expected value of a loan portfolio
at the end on one year and U the value of the
portfolio in the worst case scenario at the 99%
confidence level, which of the following expressions
correctly describes economic capital required in
respect of credit risk? E-U
Credit Risk
Losses in a bonds value from a credit
downgrade
Losses arising from a bond is.
Under the credit migration approach to assessing
portfolio credit risk, which of the following are
needed to generate a distribution of future portfolio

o
o
o
o

values? The forward yield curve, a rating migration

matrix and a specified risk horizon.
If F be the face value of a firms debt, V the value of
its assets and E the market value of equity, then
according the option pricing approach a default on
debt.F>V.
CreditMetrics: Credit Migration framework
CreditPortfolio: Credit Metrics + Impact of
the business cycle
KMV, EDF= Relies on expected defaultand
distance to default.
CreditRisk+= default as a binary event-thateither happens-or-does-not-happen
contingent claims approach: option theory by
considering a debt as a put option on the
assets of the firm.
The credit risk horizon for credit VaR is generally
one year.
Credit VaR= EL- Value of portfolio at CL
Equity correlations are used as proxies for asset
correlation.
Conditional default probabilities are modeled as a
logit function CreditPortfolio view. That ensures the
resulting probabilities are well behaved, take a
value between 0 and 1.
Under the CreditPortfolioView model of credit risk,
the conditional probability will be lower than the
unconditional probability of default in an economic
expansion.
Under the Credit Portfolio View approach to credit
risk-modeling, which of the following best describes
the conditional transition matrix? The conditional
transition matrix is the unconditional transition
matrix adjusted for the state of the economy and
other macroeconomic factors being modeled.
The principle underlying the contingent claims
approach to measuring credit risk equates the cost
of eliminating credit risk for a firm to be equal to
the value of a put on the firms assets with a strike
equal to the value of the debt.
Factors that affect credit risk
Leverage in the capital structure
Volatility of the firms asset value,
Maturity of the debt

o
o

Under the contingent claims approach to credit risk,

risk increases when volatility of the firms assets
increases and maturity of the debt increases.
Under KMV-EDF firms default on obligations is
likely when asset values reach a level between
short term debt and total liabilities
Distance-to-Default=( EV-DP)/rho
EV= expected value
DP= default point
DP= short term debt+ (1/2)*Long term debt
DD= Default frequencies {proprietary data }
CreditRisk+
The approach considers only default risk, and
ignores the risk to portfolio value form credit
downgrades.
Loss provisioning is intended to cover expected
loses. E (= unexpected losses)
Calculate the 1-year 99% credit VaR of a portfolio,
each with a value of 1 million, and the probability of
default of 1% each over the next year. Assume the
recovery rate to be zero, and the defaults to be
uncorrelated? (See notebook for more details)
There are three bonds in a diversified bond
portfolio, whose default probabilities are
independent of each other, an equal to 1%, 2%,
and 3%. Respectively over a 1 year time horizon.
Calculate the probability that exactly 1 of the three
bonds will default?
The probability that only one of the three
bonds will default= sum of the probabilities
set the three scenarios where one bond
defaults and the other two survive.
1%*(1-2%)(1-3%) + 2% (1-1%)(1-3%)
+ (1-1%)(1-2%)*3%
Marginal default probabilities refer to probabilities
of default in a particular period, given survival at
the beginning of that period.
Credit reserves are created in respect of expected
losses, which are considered the cost of doing
business. Unexpected losses are borne by
economic credit capital, when is a part of economic
capital.
Total expected losses are equal to the sum of
expected losses in the individual underlying
exposures while total unexpected losses are less

o
o

o
o
o

o
o
o

o
o

than the sum of unexpected losses on underlying

exposures.
For a loan portfolio, unexpected losses are charged
against economic credit capital.
Economic credit capital (parameters to be
determined). Definition of credit losses, Confidence
level and risk horizon.
The minimum capital requirement for credit risk per
Basel II is 8% of risk weighted assets.
The standardized approach and the internal ratings
based approach.
Under the IRB approach for risk weighted assets:
loss given default, effective maturity and exposure
at default.
Basel II required banks to conduct stress testing in
respect of their credit exposures in addition to
stress testing for market risk exposures. Basel II
requires pooled probabilities of default to be used
for credit risk capital calculations.
EC is a measure of the level of capital needed to
maintain a desired credit rating.
Capital adequacy implies the ability of a firm to
remain a going concern.
A most conservative economic capital estimate
results from which of the following assumptions:
Assuming that risk estimates {m,c,c} are
perfectively positively correlated.
The Options theoretic approach to calculating
economic capital considers the value of capital as
being equivalent to a call option with K= notional
value of debt
An approach used to allocate economic capital to
underlying business units is incremental, standalone, or marginal.
Economic capital is sub-additive.
Incremental capital for the business unit in
consideration, an appropriate measure of the
resulting reduction in capital requirement.

Operational Risk
Most financial institutions have developed initiative aimed at
improving the management of operational risk. Operational risk
encompasses risks emanating from all areas of the organization.
Operations risk
o Loss due to complex systems and processes.
o Investment Bank: High Risk

o Commercial Bank: Med Risk

Operations settlement risk
o Loss due to failed settlements
o Investment Bank: High Risk
o Commercial Bank: Low risk
Model Risk
o Losses due to imperfect model or data
o Investment Bank: High risk
o Commercial Bank: Low risk
Fraud Risk
o Reputational/Financial damage due to fraud
o Investment Bank: High Risk
o Commercial Bank: Low Risk
Mis-selling Risk
o Losses due to unsuitable sales
o Investment Bank: Medium Risk
o Commercial Bank: Medium Risk
Legal Risk
o Reputational Financial damage due to fraud
o Investment Bank: High risk
o Commercial Bank: Medium Risk
Formally, it is defined as the risk of loss resulting from
inadequate or failed internal processes, people and systems or
from external events. This definition includes legal risk, but
excludes strategic and reputation risk for capital charge
purposes.
People
o Internal fraud and/or errors
o Intentional computer crime
o Misuse of confidential customer information.
Systems
o Failure of IT systems
Hardware
Software
o Unintentional operator failures
External Events
o Customer satisfaction
o Competitor activity
o Supplier exposures
o External fraud
o Damage to physical assets
Process
o Employment practices and workplace safety
o Quality of M/s
o Inadequately trained staff
o Ineffective selling
o Data entry errors.

Losses should be estimated across eight business lines and

seven types of risk as shown below.
Retail banking
Commercial banking
Trading and sales
Retail brokerage
Corporate finance
Agency services
Payment and settlement
Asset management
Execution, delivery and process management
External fraud
Clients, products and business practices
Internal fraud
Damage to physical assets
Employment practices and workplace safety
Business disruption and system failures
Operational Risk
Core operational capability
People
Client relationship
Transactional and booking systems
Reconciliation and accounting
Change and new activities
Expense and revenue
Volatility
Operational Loss= High frequency, low severity. EL, UL= Lower
frequency and higher severity
Three different approaches to allocating capital
o Basic Indicator Approach
o Standardized Approach
o Advanced Measurement Approach
Fundamental steps followed in operational risk assessment
process for each business unit are
o Inputs to risk catalogue
o Risk assessment scorecard
o Review and validation
o Outputs of risk assessment process.
Operational risk failures point the need for
o Independent management oversight
o Self-assessments by individual business units
o Expected loss is generally absorbed as an on-going
cost and managed through internal controls.
In the past few years, the financial industry has seen a greater
focus on operational risk management.
o Capital disasters

o Regulatory actions
o Industry initiatives
o Corporate programs
o Technology development
Operational Risk Management
The process of systematic analysis of critical process and
resources, and the loss events and risk factors that may
affect these processes and resources.
o Define Scope and Objectives
Business performance
Financial performance
Compliance
o Risk Identification
Identifying critical processes and resources
Describing critical processes and resources
and analyzing them.
Evaluating processes.
o Risk Estimation
o Analyze Risks
o Implement Management Actions
Risk Avoidance
Factor management
Modifies the operating environment in
which loss events arise
Loss prediction
Loss prevention
Loss control
Contingency management
Continuity of operations between the impact
of the event and the return to normal
functioning.
o Risk Financing
A variety of tools serve a broad spectrum of
risk management.
Scorecard: assess the impact and frequency
of risks
Self-Assessment: Identifies gaps and action
items, reinforce a culture of openness and
transparency.
Key risk indicators (KRI): KPI + Key Control
Indicators (KCI)
Key Performance Indicators (KPI). KRIs allow
for the early identification of problems.
Loss data collection and data management.
o Loss data collection and categorization is
fundamental for a banks self-assessment and for

o
o

operational risk quantification. Collect internal

operational loss data across all material business/
support activities, locations, and risk categories
and ensure consistency, completeness and
accuracy of model data inputs. An understanding of
operational loss types across business lines along
with identification of data input quality, integrity, or
completeness issues.
Risk self-assessments are a fundamental
component of a sound operational risk framework.
RSA is the process of conducting current and
forward-looking assessments of operational risk
exposures and their related controls or risk
acceptance.
They help in establishing a risk profile through.
Structured questionnaires and Workshops.
Scenario analysis is used as a complement to the
risk control self-assessment (RCSA) exercise in
order to estimate frequency and severity of events
where data is scarce.
KRIs are a qualitative risk monitoring tool that
tracks changes in risk levels and keeps the
management aware of shifts in the established
patterns.
A KRI is a measure that is based in at least two
numbers. They are useful in predicting losses, their
predictive power is important in conjunction with
operational risk management.
Advanced Models
Top-down models focus on aggregate
measures of an organizations performance
and seek to develop a model of the factors
and events that cause changes in that
performance. They measure operational risk
at the firm-wide level.
Implied capital model
Economic pricing model
Income volatility model
Analogue model
Bottom-up model: The operational risks of
each business unit are identified in
conjunction with an assessment of
probability and potential loss.
Audit oversight
Critical self-assessment

Key risk indicators

Earnings volatility
Casual networks
Actuarial models
Framework
Integrating qualitative and quantitative tools
Providing early warnings and escalation,
Influencing business activities
Reflecting environmental changes
Incorporating risk interdependencies.
Management applications
Management reporting
o Prioritize operational risk
sources across units, products
and processes
o Top 10 risks: Identify critical
areas that require attention.
o Cost-benefit analysis: Improve
operating efficiency and obtain
capital savings through
corrective actions.
o Risk tolerance setting:
Determine risk appetite and
budget
o RAROC integration: RAROC
optimization and more effective
use of capital
o Insurance optimization: Review
of insurance coverage and
costs.
Risk Financing
o Financial restructuring
o Asset-liability management
o Corporate diversification
o Self-insurance
o Insurance
o Hedging
o Contractual risk transfer.
Ceded RAROC= change of Return/ Change of
Economic Capital
IT outsourcing
A major business imperative to todays
business world. In the following, we discuss
the establishment of operational risk process
and tools discussed earlier or in the context
of IT outsourcing.

ORM

Cost savings
Access to IT skills and advanced
technologies
Quality of services
Resources allocation to core activities
Scalability and flexibility in IT
resources
Shorter time to market
Enhancement of e-business
applications
Key Processes
o Evaluation and selection of
outsourcing provider.
o Transitioning to the outsourcing
environment.
o Ongoing management of the
outsourcing contract.
Risk Mitigation
o Important steps in mitigating
out sourcing risk are to fully
evaluate these economic costs
and benefits at the onset.
Performance Monitoring
o On time delivery
o Cost effectiveness
o End-user satisfaction
o Timely, quality staffing
o Service availability
o Time to process requests
o Defect rates
o Standard compliance
o Size of request backlog.
o Developing a hybrid outsourcing
strategy.
o Taking an incremental
outsourcing approach
o Negotiating inflexible win-win
contract.
o Establishing exit strategies and
contingency plans.
Operational Value-at-Risk
Under the AMA (Advanced Measurement
Approaches), the regulatory capital
requirement equals the risk measure
generated by the banks internal operational

risk measurement system that is subject to

certain qualitative and quantitative criteria.
Any AMA model requires that the following
elements and inputs for determining
operational risk capital:
Internal data
External data
Scenario analysis
Internal control and business
environment factors.
Under this approach, the bank first classifies
the business units into eight separate lines
along the lines of the standardized approach.
Then the bank measures the expected loss
(EL) for each business line by applying the
formula:
EL: EI* PI* LGE
o EI= Exposure Indicator
o PI= Probability that a loss event
occurs
o LGE= Loss given events
Bank then estimates the operational
risk capital based on the expected
loss. To calculate the capital charge he
applies a fixed percentage factor
called gamma for each business line.
Thus the capital charge is obtained as
the sum of expected loss * gamma
across business lines.
o

KIma=

EIijPEijLGEij ij

K= The capital charge

under the inter
measurement approach.
EI= The level of an
exposure indicator for
each business line and
event type combination.
PE= the probability of an
event given one unit of
exposure, for each
business line and event
type combination.
LGE- the average size of
a loss given an event for

each business line and

event type combo.

= The ratio of capital

to expected loss for each

business line and event
type combination.
Loss Distribution Approaches
o Under the loss distribution
approach (LDA), banks primarily
need to calculate two
distributions. One for the
frequency and the other for
severity of the loss.
o Actuarial models that estimate
the objective distribution of
losses from historical data are
widely used in the insurance
industry. These models a
combination of two
distributions.
High
(severity)
Low(seve
rity)

4
3
Low
High
(frequenc (frequenc
y)
y)
Scaled loss (xt) can be
calculated by using the
following formula (see notebook
for details).
If n represents the number of
occurrences of loss over the
period, then the pdf is
PDF of loss frequency=
f(n), where n=0,1,2.
Usually we use Poisson
distribution to calculate the loss
frequency distribution function:
pdf of loss severity= g. (x/n)=1
x>=0
The total loss over the period is
given by the sum of individual

losses over a random number of

occurrences.
o Operational VaR models: no
normal distribution, discrete
stochastic processes and
observed losses.
o One aggregated loss
distribution that allows
predicting the total operational
losses for a given confidence
level.
o Operational loss data is rarely
available for Low frequency,
high severity.
Information management
o The key component of the risk
infrastructure. The firms, in
order to address key issues
related to liquidity risk, have
adapted better risk
management and techniques.
o This has led to an increased use
and sophistication of dynamic
stress testing technique. This
trend has amplified the need for
information, in terms of the
information availability, quality
and most importantly, the
flexibility of information usage.
o Information risk is a major blind
spot in enterprise risk
management and every firm
operating in financial markets
struggles to manage its
information risk. Monitoring,
management, and
measurement.
o Quantitative models have been
used for valuing complex
derivatives and to calculate the
market and credit risk of these
derivatives
Misspecification risk
Misapplication risk

Incorrect implementation
risk
Transparency, Risk Monitoring
Information availability
Causes for poor data
Lack of historical data
Data completeness
Detailed data
Data quality
The process for solving data
quality problem
Assessing current state
Evaluation of the quality
of information within the
firm is extremely
important.
Integration, Integrity,
Completeness,
Accessibility, Flexibility,
Extensibility, Timeliness,
and Audibility.
Risk information is sourced from
and distributed to all parts of
the organization.
Data Governance

o
o

Data Privacy
and Security

Data
Qualit
y

Logical Data
Model
Metadata

Master
Data
Manage
ment

Data Stewardship
Firms must ensure that the
data is appropriately
structured, so that highquality information can be
generated .LDM is also
referred to as an enterprisewide blueprint for data which

serves to resolve data

element and relationship
ambiguities. All
organizations should strive
to create a unified complete
business model.
The methodology for
progressively implementing
a risk information
management environment
parallels the process of
deriving risk information
requirements.
o Assess the current
data environment.
o Design a future-state
data environment,
based on well thought
out requirements, and
identify gaps between
current and future
state.
o Develop a future-state
implementation road
map.
o Implement the
roadmap in increment
steps that generate
value at each steps.
All organizations should
strive to create only one
data model standard as
more than one business
model would consume time
and create confusion.
The entire financial system
is made of zero-sum
securities and contracts, and
therefore is believed to be a
zero-sum in aggregate.
Other Considerations
o The definition of operational risk per
Basel II includes risk of loss resulting from
inadequate or failed internal processes,

people and systems or from external

events.
EVT, when used in the context of
operational risk measurement, focuses on
tail events and attempts to build a
distribution of losses beyond what is
covered by VaR.
External fraud is a type of loss due to acts
due by third parties intended to defraud,
misappropriate property or circumvent
the law.
Banks using the basic indicator approach
must hold 15% of the average annual
gross income for the past three years,
excluding any year that had a negative
gross income.
Under the standardized approach, banks
activities are divided into eight business
lines.
According to Basel II, in any given year,
negative capital charges (resulting from
negative gross income) in any business
line may offset positive capital charges in
other business lines without limit.
Risk indicators are after the fact
indicators of performance, whereas risk
drivers represent factors that an
institution usually has control over to
influence its risk profile.
Top down approaches rely upon available
data such as total capital, income
volatility, peer group information etc and
attempt to imply the capital attributable
to operational risk. Bottom up approaches
on the other hand attempt to determine
operational risk capital based upon an
identification and quantification of firm
specific risks.
Top down approaches rely upon high level
data while bottom up approaches need
firm specific risk data to estimate risk.
Scenario analysis can help capture both
qualitative and quantitative dimensions of
operational risk.

o
o

o
o

A bank expects the error rate in

transaction data entry for a particular
business process to be 0.005%. What is
the range of expected errors, in a day
within +/- 2 standard deviations if there
are 2* 10^6 transactions per day?
Lambda= np; Lambda= np; 100+(2*10)
The generalized Pareto distribution, when
used in the context of operational risk,
used to model tail events.
When modeling operational risk using
separate distributions for loss frequency
and loss severity, loss severity and loss
frequency are considered independent.
The definition of OR excludes strategic
and reputational risk.
IT Accounting Risk Analysis Traders
When compared to a low severity high
frequency risk, the operational risk capital
requirement for a medium severity
medium frequency risk is likely to be
higher. The capital requirement will be
the worst case losses at a given
confidence level less expected losses,
and in such cases this can be expected to
be low.
Basel II accord 99.9% confidence level
over a 1 year time horizon.
Once the frequency distribution has been
determined and the severity distribution
has also been determined (for example,
using the lognormal gamma or other
functions), the loss distribution can be
produced by a Monte Carlo simulation
using successive for each of these two
distributions. It is assumed the severity
and frequency are independent of each
other. The resulting distribution gives a
distribution showing the losses for
operational risk, from which the OPRisk
VaR can be determined using the
appropriate percentile.

o
o

o
o

The frequency distribution for operational

risk loss events can be modeled by which
of the following distributions: The
binomial distribution, the Poisson
distribution, and the negative binomial
distribution.
Confidence levels for economic capital
calculations are driven by desired credit
ratings. Loss distributions for operational
risk are affected more by the severity
distribution than the frequency
distribution than the frequency
distribution. The loss distribution under
the LDA is estimated by separately
estimating the frequency and severity
distributions.
The loss severity distribution for
operational risk losses events is generally
modeled by which of the following
distributions: Lognormal, gamma density,
hyperbolic, lognormal mixtures.
EVT, practitioners often use which of the
following distributions to model loss
severity: The Peaks-over-threshold (POT)
model and the generalized Pareto
distributions.
Permitted approach: AMA, standardized
approach, the basic indicator approach.
The basic indicator approach: 15% of the
average gross income (considering only
the positive years) of the past three
years.
Under the Standardized approach to
determining operational risk capital,
operations risk capital to a fixed
percentage (different for each business
line) of the gross income of the eight
specified business lines, averaged three
years.
The frequency of losses is independent
from the severity of the losses.
Model Risk
Incorrect parameter estimation
Programming errors
Misspecification of the model

Earnings-at-risk expected earnings less

earnings under the worst-case scenario at
a given level of confidence.
Information risk is indeed the risk of not
processing and distributing critical risk
information to the managers in a timely
manner in an institution.
A training set is a set of data used to
create a model, while a control set is a set
of data is used to prove that the model
actually works? Lack of information on the
quality of underlying securities and assets
was a major case of the collapse in the
CDO markets arising from the credit crisis
that started in 2007.
The correct order of steps to addressing
data quality problems in an organization
would include: Assessing the current
state, Designing the future state and
planning and implementation which
would include identifying the gaps
between the current and desired future
state, and implementation to address the
gaps.
A banks detailed portfolio data on
positions hold in a particular security
across the bank does not agree the
aggregate total position for that security
for the bank. What data quality attributes
is missing in this situation? Data integrity.
Retail Risk Based Pricing involves using
borrower specific data to arrive at both
credit adjudication and pricing decisions.
A Logical Data Model (LDM) lays down the
relationships between data elements that
an organization stores.
The two defining characteristics of the
financial system prior to the
commencement of the current credit
crisis in 2007? Complexity and
homogeneity.
The system was robust against small
random shocks, but not against large
scale disturbances to key hubs in the

network. Feedback effects under stress

accentuated liquidity problems.
Long tailed degree distribution of the
nodes of the financial network is long
tailed.
The average path length connecting any
two given institutions has shrunk knife
edge dynamics imply that systematic risk
arises from the financial system flipping
from risk sharing to risk spreading.
The systematic manifestation of the
liquidity crisis during the current credit
crisis took many forms? Drying up of
liquidity in the cash market for treasury
bonds.
An intention to diversify from their core
activities led all market participants to the
same activities, which though appearing
diversified at the banks level, create
concentration risk at the systematic level.
The existence of central counterparties
could have limited the damage caused by
the financial crisis. Counterparty risk was
difficult to gauge as it was impossible to
know what the counterpartys
counterparties were.
The risks faced by a bank from holding a
portfolio of residential mortgages are
interest rates, default and prepayment
risks on its mortgages.
Timeline of 2008 crisis: Mortgage defaults
increased, Asset prices for CDOs
collapsed, Banks refused to lend or
transact with each other, Collapse in
prices of unrelated assets as banks tried
to create liquidity.
That which contributed to the systematic
failure in 2009? Moral hazard form the
strategy of originate and distribute,
Stress tests that did at stress enough,
inadequate attention paid to liquidity risk.
Stress testing was performed as an
isolated exercise within the risk function
without business units input. Funding

liquidity was not adequately covered as

part of the stress tests. Risk managers did
not conduct stress tests using scenarios
that were severe enough.
The following were not covered in detail
in most stress tests:
The behavior of complex structured
products under stressed liquidity
conditions.
Pipeline or securitization risk
Basis risk in relation to hedging
strategies
Counterparty credit risk
Contingent risks
Funding liquidity risk.
The spread of contagion from the
bankruptcy of one participant leading to a
similar outcome for other market
participants.
The ultimate responsibility for the overall
stress testing programme of an
institution: The Board
Stress tests can be particularly useful in
identifying risks with raw products. Stress
testing is a powerful communication tool
that can convey risks to decision makers
in an organization.
A bank valuates the impact of large and
severe changes in certain risk factors on
its risk using a quantitative valuation
model. Scenario analysis.
Attributes of a robust stress testing
programme at a bank. Data of
appropriate quality and granularity.
Written policies and procedures and
robust system infrastructure.
Examples of risk concentration
Large combined positions in assets
affected by different risk factors
that are highly correlated.
Origination of a large number of
SIVs with exposures to the same
asset class, where SIV are separate
legal entities without recourse to
the originator.

Location of a portfolios assets in a

single country but spread across
different industries.
Stress tests that start from a known
stress test outcome and then ask what
events could lead to such an outcome for
the bank.
Stress tests should consider simultaneous
pressures in funding and asset markets,
and the impact of a reduction in liquidity.
A reverse stress test that is useful for
discovering hidden vulnerabilities and
inconsistencies is hedging strategies.
Reputational risk, which is explicitly
excluded from the definition of
operational risk under Basel II, should still
be considered as part of stress tests.
In January, a bank buys a basket of
mortgages with a view to securitize them
by April. Due to unexpected lack of
investors in the securitization market, it is
unable to do so and is left with the
exposure to the mortgages on its books.
Pipeline and warehousing risk.
As part of designing a reverse stress test,
at what points should a banks business
plan be considered unviable (ie the point
where it can be considered to have
failed)? When the realization of risks
leads market participants to lose
confidence in the bank as counterparty or
a business worthy of funding.
Ensure that a firm can survive long
enough after risks have materialized for it
to either regain market confidence,
restructure or be sold, or be closed down
in an orderly manner, discover the
vulnerabilities of the current business
plan. Better integrate business and
capital planning.
The SCAP was essentially a stress test
where the stress scenarios were specified
by the regulators. Capital buffers
calculated under the SCAP represented

o
o

o
o

the amount of capital that the institutions

covered by SCAP held in excess of Basel II
requirements.
The SCAP is a replacement for Basel II for
banks located in the US. The SCAP
covered residential mortgage assets in
the trading book as well as securities that
were held to maturity.
Intra-group exposures reputational
contagion and complex group structures
(Group risk).
The speed with which new equity can be
issued to the owners is a consideration in
determining the liquidity needs of a firm.
Time horizon for liquidity risk
management are impacted by both
regulatory requirements are the speed at
which new sources of liquidity can be
tapped. Collateral management is an
important aspect of liquidity risk
management. The maturity period of
various instruments in the capital
structures as significant impact on
liquidity needs.
Funding diversification refers to
diversification of both funding sources
and funding tenors.
Early warning indicator in relation to the
health of an account or party?
Falling stock price
Negative publicity
Credit rating downgrade
The US Fedwire is an example of a Real
Time Gross System.
A contingency funding plan is like a
disaster recovery plan to deal with a
liquidity crisis. Reputational damage may
result if the market finds out that a firm
has had to execute its CFP.
Market liquidity risk presents themselves
in the form of higher bid-offer spreads.
Collateral and close out netting
arrangements are considered asset based
credit enhancement.

o
o

Counterparty based credit enhancements

are credit default swaps and close out
netting arrangement.
Deterioration in the balance sheets of key
counterparties is a concern for a liquidity
manager even though it may not
immediately affect a firm.
Residual liquidity gap is a most complete
measure of the liquidity gap facing a firm.
Liquidity at Risk?
Historical simulation
Scenario analysis
Monte Carlo simulation
Information on liquidity mismatches.
Funding concentration, lending
concentration and a report on illiquid
assets.
Book Value to Share Price: Measures of
liquidity risk.