XIM UNIVERSITY

BRM: 2022-24: CREDIT RISK

Amulya Rout
 Credit Risk
&
Credit Risk Modeling

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Credit Risk Modelling is the best way for lenders to
understand how likely a particular loan is to get repaid.
➢ It is a tool to understand the credit risk of a borrower.
➢ This is especially important because this credit risk
profile keeps changing with time and circumstances.
➢ In the lending business lender witness how dramatically
loan portfolios can change over relatively short time
frames, and how detrimental those changes can be to
both topline & bottom line.
➢ Credit risk modelling refers to two important things.
a. Probability of the borrower defaulting on the loan
b. The impact on the financials of the lender if this
default occurs.

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Credit Risk is critical to the following:

a. Banks are quantitative in the treatment of Credit

Risk
b. New markets are emerging in:
➢ Credit Derivatives
➢ Marketability of existing loans like
▪ Securitization
▪ Loan Sales
c. Regulators are concerned about improving the
current system of Capital Requirement considering
the Credit Risk
Credit Risk Model is required for the following:
a. Sanction of Credit Facilities
b. Rating of Credit Proposals in the pipeline
c. Pricing the credit instruments based on credit risk
profile
d. Early warning signals
e. Optimizing Banks /FI asset portfolio
f. Credit Collection Strategies
g. Assessing the Expected Loss (EL) of single borrower
h. Measuring the Economic Capital of Banks /FIs
i. Estimating Credit Concentration Risk
Mark-to-Market is designed to provide the current market
value of a company's assets by comparing the value of the
assets to the asset's value under current market conditions.
➢ The purpose of the mark-to-market methodology is to
give investors a more accurate picture of the value of a
company's assets.
➢ There are two well-known approaches in the mark-to-
market paradigm :
a. Discounted contractual cash flow approach
b. Risk-neutral valuation approach

(This is heavily used in the pricing of financial derivatives due to the

fundamental theorem of asset pricing, which implies that in a complete
market a derivative's price is the discounted expected value of the
future payoff under the unique risk-neutral measure.)
a. Discounted contractual cash flow approach
▪ In the discounted contractual cash flow approach, the current
value of a non-defaulted loan is measured as the present
value of its future cash flows.
▪ The cash flows are discounted using credit spreads which are
equal to market-determined spreads for obligations of the
same grade.
▪ If external market rates cannot be applied, spreads implied by
internal default history can be used.
▪ The future value of a non-defaulted loan is dependent on the
risk rating at the end of the time horizon and the credit
spreads for that rating.
▪ Therefore, changes in the value of the loan are the result of
credit migration or changes in market credit spreads.
▪ In the event of a default, the future value is determined by the
recovery rate, as in the default mode paradigm.
b. Risk-neutral valuation approach
➢ Derived from derivatives pricing theory.
➢ Prices are an expectation of the discounted future cash flows in
a risk-neutral market.
➢ Default probabilities are therefore called risk-neutral default
probabilities and are derived from the asset values in a risk-
neutral option pricing approach.
➢ Cash flow in the risk-neutral approach depends on being no
default. If a payment is contractually due on a certain date, the
lender receives the payment.
➢ If the borrower defaults before this date, the lender receives
nothing.
➢ If the borrower defaults on this date, the value of the payment
to the lender is determined by the recovery rate (1 - LGD rate).
➢ The value of a loan is equal to the sum of the present values of
these cash flows.
a. Altman’s Z score model

b. Credit Metrics Model

c. Value at Risk Model

d. Merton Model

e. KMV Model
Usage of Z score of the firm
Original Z-Score for public Manufacturing Companies:
Z-Score Forecast
➢ Above 3.0 :Bankruptcy is not likely
➢ 1.8 to 3.0 :Bankruptcy can not be predicted (Gray area)
➢ Below 1.8 :Bankruptcy is likely

Model A Z-Score for Private Manufacturing Companies:

Z-Score Forecast
➢ Above 2.9 :Bankruptcy is not likely
➢ 1.23 to 2.9 :Bankruptcy can not be predicted (Gray area)
➢ Below 1.23 :Bankruptcy is likely
Usage of Z score of the firm
Model B Z-Score for private general Companies:

Z-Score Forecast

➢ Above 2.60 : Bankruptcy is not likely

➢ 1.10 to 2.60 :Bankruptcy can not be predicted (Gray area)
➢ Below 1.10 :Bankruptcy is likely
Credit Metrics Model is the assessment of Portfolio Risk
due to changes in debt value caused by changes in credit
quality.
Applications:
• Reduces portfolio risk
• Sets exposure limits
• Identify correlations across portfolio
➢ Reduce potential risk concentration
➢ Results in diversified portfolio
➢ Reduction of total risk
Credit Metrics approach is designed to measure the risk of
credit loss caused by changes in the creditworthiness of
borrowers.
Loss does not occur only in the case of counterparty's
default, but also upon its transition into worse rating
category.
Credit metrics methodology is used to quantify the credit
risk across a broad range of instruments, including :
▪ Traditional loans
▪ Commitments and letters of credit
▪ Fixed income instruments
▪ Commercial contracts like trade credits and receivables
▪ Market-driven instruments such as swaps, forwards and
other derivative.
▪ The relationships between exposure and the credit
metrics framework develop a portfolio value due to
credit risk.
▪ As and when a debtor’s (bond issuer’s) credit rating
falls, the debtor’s bond cash flows become more deeply
discounted and the total bond value drops accordingly.
▪ On the other hand, if a debtor’s rating improves, the
cash flows are discounted less deeply, and the bond
values will rise.
Value at Risk (VaR) is a measure of the risk of loss for
investments.
▪ It estimates how much a set of investments might lose (with a
given probability), given normal market conditions, in a set
time period such as a day or a week even.
▪ VaR is typically used by firms and regulators in the financial
industry to gauge the amount of assets needed to cover
possible losses.
▪ For a given portfolio, time horizon, and probability p,
the p VaR can be defined informally as the maximum possible
loss during that time after we exclude all worse outcomes
whose combined probability is at most p.
▪ This assumes mark to market pricing, and no trading in the
portfolio.
• Estimate of potential loss in loan portfolio over a given
holding period at a given level of confidence.
• Probability distribution of a loan portfolio value
reducing by an estimated amount over a given time
horizon.
• Time horizon estimate is over a daily, weekly or
monthly basis.

Value at risk is used by risk managers to measure and

control the level of risk which is undertaken and to ensure
it is within limits.
a. VAR gives one single risk measure aggregating all positions
in a spot or derivatives market.
b. It is measured in the three variables—the amount of potential
loss, the probability and the time frame.
c. For example VaR of 2% at 99% confidence over 5 days
indicates that the portfolio value will not depreciate more
than 2% over the next 5 days with 99% certainty.
d. It can be defined as a statistical technique used to used to
measure and quantify the level of financial risk within a firm
or faced by an investment portfolio over a specific time
frame.
e. VaR is used by risk managers to measure and control the
level of risk which is undertaken and to ensure it is within
limits.
Merton Model is an analysis model named after
economist Robert C Merton that is used to assess the
credit risk of a company's debt.
▪ Analysts at brokerage firms and investors utilize the
Merton model to understand how capable a company is
at meeting financial obligations.
▪ It will indicate how servicing its debt and weighing the
general possibility that the company will go into credit
default.
▪ Merton’s model is a structural model of default in
which default occurs at the maturity when the market
value of the company’s assets fall below a pre-
determined threshold defined by liabilities.
▪ Bank would default only if its asset value falls below
certain level (default point), which is a function of its
liability.
▪ Estimates the asset value of the bank and its asset
volatility from the market value and the debt structure
in the option theoretic framework.
▪ A measurement that represents the number of standard
deviation that the bank’s asset value would be away
from the default point.
The major advantage of Merton's model is the use of
current market prices to determine the probability of
default.
In 1974 Merton proposes a model where a company’s equity is
an option on the asset of the company.
Suppose a company has zero-coupon bond outstanding and
that the bond matures at:
T : time, V0 : Value of the company’s assets today, VT: Value of the
company’s assets at time T, E0: Value of the company’s equity
today, Er: Value of the company’s equity at time T,
D: Amount of debt interest and principal due to be repaid at time T,
av: Volatility of assets (assumed constant), aE: Instantaneous
volatility of equity.
▪ Suppose VT<D, it is (at least in theory) rational for the company
to default debt at time T.
▪ If VT>D, the company should make the debt payment at time T
and the value of the equity at this time is VT-D & therefore
Merton’s model, gives the value of the company’s equity as:
Et=max (VT-D, 0)
➢ Historical default experience to compute Expected Default
Frequency (EDF)
▪ Expected default frequency (EDF) is arrived at from
historical data in terms of number of banks that have
Distance from Default (DFD) values similar to the bank’s
DFD in relation to the total number of banks considered
for evaluation.

➢ Distance from Default (DFD) is the estimation of asset value

and asset volatility and volatility of equity return
▪ DFD = (Expected asset value – Default point) / (Asset
value x Asset volatility)

Model Efficiency
▪ Difference between the estimated default values and
actual default rate
▪ Expected asset value (1 year hence) 200 crores
▪ Default point (DP) 140 crores
▪ Volatility of asset value 12%
▪ Asset value 250 crores

E (Vt ) − DP 200 − 140

DFD = = = 2.00
 v V 0.12  250

▪ If from historical observation the number of banks

among 80 banks that have a default point of 2.00 are
12, then EDF = 12/80 =15%
 Relationship between DFD and EDF

EDF

15%

2.0 DFD
The KMV (Kealhofer Merton Vasicek) model is a credit
risk model that Kealhofer, Merton, and Vasicek
developed to estimate the Probability of Default (PD) and
the expected Loss Given Default (LGD) for a company or
a portfolio of companies.

▪ The KMV approach follows the same logic as the

structural approach to a point, ie, the firm defaults when
the value of assets falls below a certain level.
▪ But as an end product, it comes up with the Expected
Default Frequency (EDF) (ie the probability of default).
▪ Similar to what was explained for the structural
approach, default happens when the value of assets falls
below a certain value, called the ‘default point’.
➢ The ‘default point’ under KMV is not the same as the point
where the value of the assets falls below the value of the total
debt.
➢ Over time, the assets of the firm will earn a certain return and
trend with a given mean and volatility.
➢ Under KMV, the returns on the firm’s assets are normally
distributed.
➢ The KMV model requires a combination of company-specific
data and market-based information.
▪ Company-specific data typically includes financial statements,
capital structure, asset values, and liabilities.
▪ Market-based information may include stock prices, interest
rates, credit spreads, and other relevant market indicators.
▪ These inputs estimate the firm’s asset value, default threshold,
and other necessary parameters.
2.
➢ The accuracy of the KMV model in predicting default
probabilities depends on the quality and reliability of the
input data, the appropriateness of the model assumptions,
and the calibration of the model to historical default data.
➢ The KMV model applies to a wide range of companies,
including public corporations, private firms, and even
portfolios of companies.
➢ However, the availability and quality of data inputs may vary
depending on the company’s size, industry, and market
coverage.
➢ The KMV model aligns with the risk management practices
and frameworks recommended by regulatory authorities.
➢ Its utilization can assist financial institutions in meeting
regulatory requirements related to credit risk assessment and
capital adequacy.
There are essentially three steps to the credit risk assessment
process under the KMV approach:

A. Determine the value of assets (V) and their volatility (σ)

The value of equity (as represented by the stock price, S) is driven by:

▪ Value of the firm’s assets (V)

▪ The volatility of the assets (σ)
▪ The leverage ratio (L)
▪ The coupon on long term debt (c) and
▪ The risk-free rate (r)

Of the above, the last three are known variables, and so is the
stock price. The only unknown variables are V and σ. The
volatility of the assets is not the same as the volatility of the stock
price, as the latter is driven by the value of the assets.
B. Calculate the ‘distance to default’ (DD)
▪ A key concept underlying the KMV approach is the
recognition that a firm does not have to default the moment
its asset value falls below the face value of debt.
▪ Default happens when value of the firm’s assets falls
somewhere between the value of the short term debt and the
value of the total debt.
▪ In other words, it is possible to not have default even if the
value of the assets has fallen to less than the total debt.
▪ KMV sets the default point as somewhere between short
term debt (STD) and the total debt as the total of the short
term debt and half the value of the long term debt.

Default Point= Short Term Debt + ½ Long Term Debt

▪ Next, the KMV approach determines what the ‘distance-to-
default (DD)’ is.
C. Determination of the EDFs

The last step is the determination of the Expected Default

Frequencies, which is a mapping of the distance-to-default to
probabilities of default based upon a proprietary database
(provided to customers using the ‘Credit Monitor’ service).

Based upon what was explained above, EDFs are affected by:
▪ Stock price
▪ Leverage ratio and
▪ Asset volatility.
Difference between Merton Model & KMV Model
➢ Both models are used for Credit Risk Assessment of Firms.
➢ They are default forecasting model that produces a
probability of default for each firm at any given point in time

Merton Model to understand how capable a company is at

meeting financial obligations focusing on the valuation of debt
.
KMV Model primarily focuses on the probability of default of
the company while the Merton model focuses on the valuation
of debt.
The KMV model finds applications in credit risk evaluation,
portfolio risk management, pricing of credit-sensitive
instruments, stress testing, scenario analysis, and risk-based
capital allocation.
 KMV Model Merton Model
Combines elements from structural and Focuses solely on the structural
reduced-form approaches to credit risk. approach to credit risk.

Estimates the probability of default (PD) Estimates the probability of default

and expected loss given default (LGD). (PD) but does not explicitly
estimate LGD.
Considers both company-specific Relies primarily on company-
financial data and market-based specific financial data for
information in the estimation process. estimation
Provides a comprehensive framework for Offers a simplified approach to
credit risk assessment and management. credit risk estimation.

Widely used in financial institutions for Primarily used for academic and
credit risk evaluation, portfolio risk theoretical purposes.
management, and risk-based capital
allocation.
Needed procedures
▪ Documentation made for all credit related transactions
▪ Collateralized transactions monitored regularly
▪ Legally binding terms for the credit transaction
▪ Review of borrower performance profile
▪ Alternate options in terms of loan restructure to
changed scenarios
Thank You