Credit Risk Rating Model

The Credit Risk Rating Model is used to assess the creditworthiness of borrowers or counterparty
entities. It assigns a rating, or score based on various factors that indicate the likelihood of default. Here
are two simple calculations and illustrations for a Credit Risk Rating Model:

Five-Point Credit Rating Model:

In this model, a five-point scale is used to assign credit ratings to borrowers. Let's consider four factors to
determine the credit rating: credit history, financial stability, collateral, and industry risk. Each factor is
assigned a score ranging from 1 to 5, with 1 being the lowest risk and 5 being the highest risk. The scores
are then aggregated to obtain the overall credit rating.

For example, let's assume the following scores for a borrower:

 Credit History: 4
 Financial Stability: 3
 Collateral: 2
 Industry Risk: 5

The overall credit rating is calculated by summing up the individual scores:

Overall Credit Rating = 4 + 3 + 2 + 5

Overall Credit Rating = 14

Based on this model, the borrower would be assigned a credit rating of 14, which could correspond to a
specific rating category such as "Low Risk," "Medium Risk," or "High Risk" depending on the predefined
thresholds for each category.

Probability of Default (PD) Model:

The Probability of Default (PD) model estimates the likelihood of default for a borrower. It involves
assigning a numerical probability to each borrower based on their credit characteristics and historical
default data. Let's consider two factors to determine the PD: debt-to-income ratio and credit score.

For example, let's assume the following inputs for a borrower:

Debt-to-Income Ratio: 40%

Credit Score: 650

Based on historical data and predefined thresholds, you can assign probabilities of default to specific
ranges of debt-to-income ratios and credit scores. Let's say the PDs are as follows:

Debt-to-Income Ratio:

PD of 0.05 (5%) for ratios below 30%

PD of 0.10 (10%) for ratios between 30% and 50%

PD of 0.20 (20%) for ratios above 50%

Credit Score:

PD of 0.02 (2%) for scores above 700

PD of 0.10 (10%) for scores between 650 and 700

PD of 0.30 (30%) for scores below 650

To calculate the overall PD, you can assign weights to each factor and calculate a weighted average:
Overall PD = (Debt-to-Income PD * Weight1) + (Credit Score PD * Weight2)

For example, let's assume equal weights for both factors: (Either Equal or 33.33%)

Overall PD = (0.10 * 0.5) + (0.10 * 0.5)

Overall PD = 0.10

Based on this PD model, the borrower would have an overall probability of default of 0.10 or 10%.

Credit Risk Rating Models consider a wide range of factors and more complex methodologies, including
statistical models and historical data analysis, to assign accurate credit ratings or probabilities of default