Professional Documents
Culture Documents
Modeling
Doc. RNDr. Ji Witzany, Ph.D.
jiri.witzany@vse.cz , NB 178
Office hours: Tuesday 10-12
Literature
Requirement Title
Required
Credit Risk Management and
Modeling
Optional
Managing Credit Risk The
Great Challenge for Global
Financial Markets
Author
Witzany, J.
Caouette J.B., Altman
E.I., Narayan O.,
Nimmo R.
Year of Publication
2010, Oeconomica,
pp. 214
2008, 2nd Edition,
Wiley Finance, pp.
627
Optional
2003, Princeton
University Press,
pp.396
Optional
Thomas L. C.
Optional
Schnbucher P.J.
2009, Oxford
University Press, pp.
400
2003, Wiley Finance
Series, pp. 375
Content
Introduction
Credit Risk Management
Rating Validation
Analytical Ratings
Automated Rating Systems
3
Content - continued
Expected Loss, LGD, and EAD
Basel II Requirements
Content - continued
Credit Derivatives
Overview of Basic Credit Derivatives
Products
Intensity of Default Stochastic Modeling
Copula Correlation Models
CDS and CDO Valuation
5
European Social Fund Prague & EU: Supporting Your Future
Introduction
Classical commercial bank credit risk
management
Corporate loans approval and pricing
Retail loans approval and pricing
Provisioning and workout
Regulatory requirements Basel II
Loan portfolio reporting and management
Financial markets (counterparty) credit risk
6
European Social Fund Prague & EU: Supporting Your Future
Introduction
Credit approval can we get a crystal
ball?
What is the first, the chicken or the egg,
Basel II or credit rating?
What is new in Basel III?
Should we start the course with credit
derivatives?
7
European Social Fund Prague & EU: Supporting Your Future
OTC derivatives
800 000
700 000
Billion USD
600 000
500 000
400 000
300 000
OTC derivatives
200 000
100 000
Jun
98
Jun
99
Jun
00
Jun
01
Jun
02
Jun
03
Jun
04
Jun
05
Jun
06
Jun
07
Jun
08
Jun
09
11
European Social Fund Prague & EU: Supporting Your Future
Basel II - History
1988: 1st Capital Accord Basel I (BCBS,
BIS)
1996: Market Risk Ammendment
1999: Basel II 1st Consultative Paper
2004: The New Capital Accord - Basel II
2006: EU Capital Adequacy Directive
2007: CNB Provision on Basel II
2008: Basel II effective for banks
2010: Basel III following the crisis (effective
2013-2019)
14
European Social Fund Prague & EU: Supporting Your Future
Basel II - Principles
15
European Social Fund Prague & EU: Supporting Your Future
Basel II Structure
16
European Social Fund Prague & EU: Supporting Your Future
441. Banks must have independent credit risk control units that are
responsible for the design or selection, implementation and performance of
their internal rating systems. The unit(s) must be functionally independent
from the personnel and management functions responsible for originating
exposures. Areas of responsibility must include:
Testing and monitoring internal grades;
Production and analysis of summary reports from the banks rating system,
to include historical default data sorted by rating at the time of default and
one year prior to default, grade migration analyses, and monitoring of
trends in key rating criteria;
Implementing procedures to verify that rating definitions are consistently
applied across departments and geographic areas;
Reviewing and documenting any changes to the rating process, including
the reasons for the changes; and
Reviewing the rating criteria to evaluate if they remain predictive of risk.
Changes to the rating process, criteria or individual rating parameters must
be documented and retained for supervisors to review.
17
Content
Introduction
Credit Risk Management
Rating and Scoring Systems
Portfolio Credit Risk Modeling
Credit Derivatives
19
European Social Fund Prague & EU: Supporting Your Future
PAST
Historical data
Experience
Know-how
Time horizon?
Default/Loss Definition?
FUTURE?
Probabilty of Default?
Expected Loss?
Loss distribution?
Actual Client/
Exposure/ Application
Information
20
Default History
Source: Moodys
European Social Fund Prague & EU: Supporting Your Future
23
Roll-out
Into approval
process
Redevelopment/
calibration
Data collection
ratings and defaults
Performance
measure on new data
validation
24
AR
aR
aP
27
European Social Fund Prague & EU: Supporting Your Future
Receiver Operating
Characteristic Curve
KS / 2
KS
AUC
28
In-sample or Out-sample
A rating system is usually developed (trained)
on a historical sample of defaults
When the AR of the system is calculated on
the training sample (in sample) then we
generally must expect better values than on
an independent (out sample)
Real validation should be done on a sample
of data collected after the development
31
European Social Fund Prague & EU: Supporting Your Future
32
European Social Fund Prague & EU: Supporting Your Future
Gini
69,00%
71,50%
H0: Gini(Rating1)=Gini(Rating2)
2(1)=
Prob> 2(1)=
9,86
0,17%
33
European Social Fund Prague & EU: Supporting Your Future
Measures of Correctness of
Categorical Predictions
In practice we use a cut-off score in
order to decide on acceptance/rejection
of new applications
The goal is to accept good applicants
and reject bad applicants
Or in fact minimize losses caused bad
accepted applicants and good rejected
applicants (opportunity cost)
34
European Social Fund Prague & EU: Supporting Your Future
Measures of Correctness of
Categorical Predictions
Actual goods
Actual bads
Total
Approved
gG
gB
Rejected
bG
bB
Actual numbers
nG
nB
Actual goods
Actual bads
Total
Approved
Rejected
Total actual
F c ( sc | G )
F (sc | G)
G
F c ( sc | B)
F c ( sc | G )
F (sc | B)
F (sc | G)
35
European Social Fund Prague & EU: Supporting Your Future
Measures of Correctness of
Categorical Predictions
Generally we need to minimize the
weighted cost of errors
WCE
c
F
( sc | B) q
B
G F ( sc | G )
CF c (sc | B) F ( sc | G)
w( sc ) CF c (sc | B) F ( sc | G) C CF ( sc | B) F ( sc | G )
l
q
B
G
36
European Social Fund Prague & EU: Supporting Your Future
Cut-off Optimization
Example: Scorecard 0100, proposed cut-off
40 or 50
Validation sample: 10 000 applications, 7 000
approved where we have information on
defaults
We estimate F(40|G)=12%, F(50|G)=14%,
F(40|B)=70%, F(50|B)=76%
Based on scores assigned to all applications
we estimate B=10%.
Calculate the total and weighted rate of errors if
l=60% and q=10%. Select the optimal cut-off.
37
European Social Fund Prague & EU: Supporting Your Future
Validation of PD estimates
If the rating is connected with expected
PDs then we ask how close is our
experienced rate of default on rating
grades to the expected PDs
Hosmer-Lemeshow Test one
comperehensive statistics
2
asymptotically
with number of rating
grades 2 degrees of freedom
SN
s 1
ns ( PDs ps ) 2
PDs (1 PDs )
(ns PDs d s ) 2
1 ns PDs (1 PDs )
38
Hosmer-Lemenshow Test
Example
rating (s) PD_s
p_s
N_s
1
30%
35,0%
2
10%
8,0%
3
5%
7,0%
4
1%
1,5%
Hos.-Lem.
p-value
50
150
70
50
0,595238095
0,666666667
0,589473684
0,126262626
1,977641072
0,37201522
Binomial Test
Only for one grade, one-sided
If P PDs then the probability of
observing or more defaults is at most
Ns
Ns
j d
B ( d ; N s , PDs )
PDs j (1 PDs ) N s
41
European Social Fund Prague & EU: Supporting Your Future
Ratio
Operating performance
Liquidity
Receivables
42
European Social Fund Prague & EU: Supporting Your Future
Interpretation
Investment Grade Ratings
AAA/Aaa
AA/Aa
A/A
BBB/Ba
BB/Ba
B/B
CCC/Caa
CC/Ca
C/C/D
In bankruptcy or default.
43
Altmans Z-score
Altman (1968), maximizationk of the
discrimination power by z
i xi on a dataset
i 1
of 33 bankrupt + 33 non-bankrupt companies
Z 1.2 x1 1.4 x2 2.3x3 0.6 x4 0.999 x5
Variable
Ratio
x1
x2
x3
x4
x5
Bankrupt
group mean
-6.1%
-62.6%
-31.8%
40.1%
Non-bankrupt
group mean
41.4%
35.5%
15.4%
247.7%
F-ratio
1.5
1.9
2.84
32.60
58.86
25.56
33.26
48
European Social Fund Prague & EU: Supporting Your Future
Altmans Z-score
Maximization of the discrimination function
maximization between bad/good group
variance and minimization within group
variance
N1 ( z1
z )2
N1
N 2 ( z2
z )2
N2
( z1,i
z1 ) 2
i 1
( z 2 ,i
z2 ) 2
i 1
Logistic Regression
Latent credit score yi*
Default iff yi* 0 , i.e.
pi
Pr[ yi
'xi
0 | xi ] Pr[ui xi
ui
0] F ( xi )
ex
( x)
1 ex
1
e
1
50
Logit or Probit?
PDF
CDF
0,45
1,2
0,4
0,35
0,3
0,8
0,25
0,6
Probit
0,4
Logit
0,1
0,05
0
-10
-5
Logit
0,15
0,2
-15
Probit
0,2
10
-15
15
-10
-5
10
15
1 pi
pi
51
Maximum Likelihood
Estimation
The coefficients could be theoretically
estimated by splitting the sample into
pools with similar characteristics and by
OLS
or by maximizing the total likelihood
or log-likelihood
F ( b 'xi ) yi (1 F ( b 'xi ))1
L(b)
yi
ln L(b)
l (b )
52
Estimators properties
l
bj
(y
( b'x )) x
0 for j 0,..., k
Hence
The solution is found by the Newtons
algorithm in a few iterations
The estimated parameters b are
asymptotic normal and the s.e. are
reported by most statistical packages
allowing to test the null hypothesis and
obtain confidence intervals
i
i, j
53
European Social Fund Prague & EU: Supporting Your Future
Selection of Variables
In-sample likelihood is maximized if all
possible variables are used
But insignificant coefficients where we are not
sure even with the sign can cause systematic
out-sample errors
The goal is to have all coefficients significant
at least on the 90% probability level and at
the same time maximize the Gini coefficient
54
European Social Fund Prague & EU: Supporting Your Future
Selection of Variables
Generally it is useful to perform
univariate analysis to preselect the
variables and make appropriate
transformations
55
Selection of Variables
Correlated variables should be
eliminated
In the backward selection procedure
variables with low significance are
eliminated
In the forward selection procedure
variables are added maximizing the
statistic
G
(k l )
56
Categorical Variables
Some categorical values need to be
merged
Marital Status of borrower
Unmarried
Married
Widowed
Divorced
Separated
Total
12,00%
10,00%
8,00%
6,00%
% bad
4,00%
2,00%
0,00%
Unmarried
Married
Widowed
Divorced
Separated
57
European Social Fund Prague & EU: Supporting Your Future
Categorical Variables
Discriminatory power can be measured
looking on significance of the regression
coefficients (of the dummy variables)
Or using the Weight of Evidence (WoE)
WoE
Weight of Evidence
Marital Status of borrower
Unmarried
Married or widowed
Divorced or separated
Pr[c|Good]
0,64516129
0,537634409
0,462365591
Pr[c|Bad]
WoE
0,565789474 0,13127829
0,302631579 0,57466264
0,697368421 -0,410958
IV
0,24204342
IV
59
European Social Fund Prague & EU: Supporting Your Future
Weight of Evidence
WoE can be used to build a nave Bayes
score (based on the independence of
categorical variables)
Pr[c | Good ] Pr[c1 | Good ]
Pr[c | Bad ] Pr[c1 | Bad ]
Pr[c2 | Good ]
Pr[c2 | Bad ]
WoE(c) WoE(c1 )
WoE(cn )
s(c)
WoE (cn )
observations:
10,936
variables:
21
variable name
variable description
# of categorical values
id_deal
Account Number
N/A
def
mesprij
Monthly Income
N/A
pocvyz
Number of Dependents
ostprij
Other Income
N/A
k1pohlavi
Sex
k2vek
Age
15
k3stav
Marital Status
k4vzdel
Education
k5stabil
Employment Stability
10
k6platce
Employer Type
k7forby
Type of Housing
k8forspl
Type of Repayment
k27kk
Credit Card
k28soczar
Social Status
10
k29bydtel
k30zamtel
61
In-sample Out-sample
71.4%
47.9%
69.2%
54.7%
71.1%
38.8%
70.9%
38.4%
69.2%
43.6%
In-sample Out-sample
61.9%
57.7%
61.3%
58.7%
61.6%
58.0%
60.0%
62.7%
60.7%
59.5%
62
Combination of Qualitative
(Expert) and Quantitative
Assesment
63
European Social Fund Prague & EU: Supporting Your Future
Actual PD
9%
Predicted PD no calibration
8%
7%
6%
5%
4%
3%
2%
1%
Calibration date
European Social Fund Prague & EU: Supporting Your Future
30SEP2009
30JUN2009
31MAR2009
31DEC2008
30SEP2008
30JUN2008
31MAR2008
31DEC2007
30SEP2007
30JUN2007
31MAR2007
31DEC2006
30SEP2006
30JUN2006
31MAR2006
31DEC2005
30SEP2005
30JUN2005
0%
64
Ln(GB Odds)
4,0
R2=99.7%
3,0
2,0
1,0
0,0
200
300
400
500
600
700
800
900
-1,0
-2,0
NWU score
65
European Social Fund Prague & EU: Supporting Your Future
Shadow Rating
Not enough defaults for logistic regression
but external ratings e.g. Large
corporations, municipalities, etc.
Regression is run on PDs or log odds
obtained from the ratings and with
available explanatory variables
The developed rating mimics the external
agency process
Useful if there is insufficient internal
expertise
67
European Social Fund Prague & EU: Supporting Your Future
Survival Analysis
So far we have implicitly
assumed that the probability
of default does not depend on
the loan age empirically it
is not the case
68
European Social Fund Prague & EU: Supporting Your Future
Survival Analysis
T - time of exit
f (t ), F (t ) - probability density and
cumulative distribution functions
S (t ) 1 F (t ) - survival function
f (t )
(
t
)
- hazard function
S (t )
The survival function can be expressed
in terms of the hazard function that is
modeled primarily
69
European Social Fund Prague & EU: Supporting Your Future
ln L()
ln (t | )
uncensored
observations
ln S (t | )
all observations
70
(t )exp( x ' ),
Li ()
j Ai
exp( xi ' )
exp( x j ' )
ln L
i 1
j Ai
Lt
dNi ( t )
(
t
)
exp(
x
'
)
]
exp(
0
i
ln Li
i 1
71
European Social Fund Prague & EU: Supporting Your Future
72
European Social Fund Prague & EU: Supporting Your Future
73
European Social Fund Prague & EU: Supporting Your Future
1 PD
ELabs = PD*LGD*EAD
74
European Social Fund Prague & EU: Supporting Your Future
Approval Parametrization
NO
YES
Increase of
Marginal
Def ault Rate
f rom 12% to 14%
2
Increase of
Average
Def ault Rate
f rom 5% to 6%
Cut Off:
Changed
1
Accepted Applications
75
European Social Fund Prague & EU: Supporting Your Future
Marginal Risk
Marginal Default Rate According to Average Default Rate
35%
30%
25%
20%
18.9%
15%
13.7%
11.8%
10%
5%
10%
9%
8%
7%
6%
5%
4%
3%
2%
1%
0%
76
European Social Fund Prague & EU: Supporting Your Future
Cut-off Optimization
Net Income According to Average Default Rate of Accepted Applicants
Optim al Point
Net Incom e is Maxim al
160
150
Income Line
Net Income
140
130
120
110
100
90
4.2%
10%
9%
8%
7%
6%
5%
4%
3%
2%
1%
80
77
European Social Fund Prague & EU: Supporting Your Future
1
EAD
i 1
CFti
(1 r )
ti
79
European Social Fund Prague & EU: Supporting Your Future
LGD Regression
Pool level estimations basic approach
Advanced: account level regression
requires a sufficient number of
observations
LGDi
f ( ' xi )
RR Pro-cyclicality
Exposure at Default
What will be the exposure of a loan in case of
default within a time horizon?
Relatively simple for ordinary loans but
difficult for lines of credits, credit cards,
overdrafts, etc.
Conversion factor CAD mandatory
parameter
EAD
CF (a, tr )
Ex(td ) Ex(tr )
L(tr ) Ex(tr )
83
84
European Social Fund Prague & EU: Supporting Your Future
1
| RDS (l ) | o
CF (o)
RDS ( l )
( EAD(o) Ex(o))
( L(o) Ex(o))
CF (l )
EAD(o) Ex(o)
( L(o) E (o))
85
Basel II Requirements
Capital Ratio
Total Capital
Credit Risk Market Risk Operational Risk RWA
86
European Social Fund Prague & EU: Supporting Your Future
Sovereign Risk
Weights
Bank Risk
Weights
Rating
Corporate Risk
Weights
AAA to AA-
0%
20%
AAA to AA-
20%
A+ to A-
20%
50%
A+ to A-
50%
BBB+ to BBB-
50%
100%
BBB+ to BBB-
100%
BB+ to B-
100%
100%
BB+ to BB-
100%
Below B-
150%
150%
Below BB-
150%
Unrated
100%
100%
Unrated
100%
Table 1. Risk Weights for Sovereigns, Banks, and Corporates (Source: BCBC, 2006a)
87
European Social Fund Prague & EU: Supporting Your Future
RWA
EADw, w
K 12.5
200%
150%
w
100%
50%
0%
0,00% 1,00% 2,00% 3,00% 4,00% 5,00% 6,00% 7,00% 8,00% 9,00% 10,00%
PD
88
Content
Introduction
Credit Risk Management
Rating and Scoring Systems
Portfolio Credit Risk Modeling
Credit Derivatives
90
European Social Fund Prague & EU: Supporting Your Future
92
European Social Fund Prague & EU: Supporting Your Future
E[ X ]
FX ( x) Pr[ X
qX
sup{x | F ( x)
UL
Normality =>
x]
qX
E[ X ]
UL VaR rel
qN
93
Credit VaR
Credit loss of a credit portfolio can be measured in
different ways
Market value based
Accounting provisions
Number of defaults x LGD
Credit VaR at an appropriate probability level should
be compared with the available capital => Economic
Capital
Economic Capital can be allocated to individual
transactions, implemented e.g. by Bankers Trust
Many different Credit VaR models! (CreditMetrics,
CreditRisk+, CreditPortfolio View, KMV portfolio
Manager, Vasicek Model Basel II)
94
European Social Fund Prague & EU: Supporting Your Future
CreditMetrics
Well known methodology by JP Morgan
Monte Carlo simulation of rating migration
Today/future bond/loan values determined by
ratings
Historical rating migration probabilities
Rating migration correlations modeled as
asset correlations structural approach
Asset return decomposed into a systematic
(macroeconomic) and idiosyncratic (specific)
parts
95
European Social Fund Prague & EU: Supporting Your Future
Bond Valuation
Simulated forward values required
calculation of implied forward discount
rates for individual ratings
P
t
CF (t )
(1 rs (t ))t
CF (t )
(1 ru (t0 , t ))t
t0
96
European Social Fund Prague & EU: Supporting Your Future
Rating Migrations
97
European Social Fund Prague & EU: Supporting Your Future
Recovery Rates
CreditMetrics models the recovery rates as
deterministic or independent on the rate of
defaults but a number of studies show a
negative correlation
98
European Social Fund Prague & EU: Supporting Your Future
99
European Social Fund Prague & EU: Supporting Your Future
101
European Social Fund Prague & EU: Supporting Your Future
D(T )
D max( D A(T ), 0)
E (T )
max( A(T ) D, 0)
/ 2)dt
dW
ln
A(0)
/ 2)
N (0,1)
102
ri
w j r ( I j ) wk
1 i
j 1
0.9r ( I )
1 0.92
0.9r ( I ) 0.44 1
0.7r ( I )
1 0.72
0.7r ( I ) 0.71 1
Portfolio Simulation
Sample systematic factors
(Cholesky decomposition)
and the specific factors
determine ratings, calculate
implied market values
Probability (%)
25
20
15
mean
10
1% quantile
median
nominal value
5% quantile
Unexpected Loss
exp. loss
0
135
140
145
150
155
160
165
170
175
Market Value
106
European Social Fund Prague & EU: Supporting Your Future
107
European Social Fund Prague & EU: Supporting Your Future
CreditRisk+
Credit Suisse (1997)
Analytic (generating function) actuarial
approach
Can be also implemented/described in a
simulation framework:
1. Starting from an initial PD0 simulate a
new portfolio PD1
2. Simulate defaults as independent events
with probability PD1
108
European Social Fund Prague & EU: Supporting Your Future
Credit Risk+
The Full Model
Exposures are adjusted by fixed LGDs
The portfolio needs to be divided into
size bands (discrete treatment)
The full model allows a scale of ratings
and PDs simulating overall mean
number of defaults with a Gamma
distribution
The portfolio can be divided into
independent sector portfolios
European Social Fund Prague & EU: Supporting Your Future
109
{0,1, 2,3,...}
pn
Pr[ X
pn z n
GX ( z )
n]
n 0
GX ( z )GY ( z )
pn z
n 0
qn z
n 0
pi qn
n 0
zn
GX Y ( z )
i 0
G( z) e
( z 1)
e
n 0
n!
zn
110
r
r 1
f ( x)
1
e x
( )
e xx
, where ( )
dx.
111
European Social Fund Prague & EU: Supporting Your Future
N PD0
0,045
0,04
0,035
0,03
f(x)
0,025
sigma=10
0,02
sigma=50
0,015
sigma=90
0,01
0,005
0
-0,005 0
100
200
300
400
500
112
European Social Fund Prague & EU: Supporting Your Future
n]
Pr[ X
n|
x] f ( x)dx
G( z )
1)
f ( x)dx
(1
Pr[ X
n] (1 q )
1
n
z)
q n , where q
.
113
nL]z n
Pr[portfolio loss
n 0
(z
mj
1)
n
j
n!
n 0
k
G( z)
G j (z)
j 1
j (z
mj
1)
mjn
where
jz
mj
( P ( z ) 1)
j 1
k
j
P( z )
mj
j 1
j 1
114
European Social Fund Prague & EU: Supporting Your Future
x ( P ( z ) 1)
f ( x)dx
(1
P( z ))
final
s 1
European Social Fund Prague & EU: Supporting Your Future
115
CreditPortfolio View
Wilson (1997) and McKinsey
Ties rates of default to macroeconomic
factors
116
European Social Fund Prague & EU: Supporting Your Future
CreditPortfolio View
Macroeconomic model
PD j ,t
Y j ,t
X j ,t ,i
j ,i ,0
(Y j ,t )
j ' X j ,t
j ,i ,0
X j ,t
1,i
j ,t
j ,i ,0
X j ,t
2,i
e j ,t ,i
M PD j ,t / PD0
117
h1 E0 ,
and
h2 E0 ,
A0 ,
f ( A0 ,
118
European Social Fund Prague & EU: Supporting Your Future
f ( A( H ),
119
max( A(T ) D, 0)
dA rAdt
E0
d1
A0 N (d1 ) De
dE
2
A
ln A0 / D (r
E
rA
A
A0
N (d1 )
E0
E
t
A
1 2E
2 A2
E0
/ 2)T
2
A
f1 ( A0 ,
AdW
rT
N (d 2 )
and d 2
E
A
dt
d1
),
A AdW
f 2 ( A0 ,
E
A
A
N (d1 )
)
120
Pr[VT
K]
( d2 )
STD LTD / 2
121
122
European Social Fund Prague & EU: Supporting Your Future
PD callibration
The distance to default is calibrated to
PDs based on historical default
observations
123
European Social Fund Prague & EU: Supporting Your Future
124
European Social Fund Prague & EU: Supporting Your Future
125
European Social Fund Prague & EU: Supporting Your Future
PV
riTi
EQ [cash flow i ]
i 1
n
riTi
CFi (1 LGD )
i 1
riTi
(1 Qi )CFi LGD
i 1
Example
Time
1
2
3
Total
CFi
5 000,00
5 000,00
105 000,00
Qi
3%
6,50%
9,90%
e^-rTi
0,9704
0,9418
0,9139
PV1
1 940,89
1 883,53
38 385,11
42 209,53
PV2
2 824,00
2 641,65
51 877,48
57 343,12
PV
4 764,89
4 525,18
90 262,59
99 552,65
126
European Social Fund Prague & EU: Supporting Your Future
A dt
A dW
EDFT
dA rAdt
AdW
QT
dA
EDFT
QT
d2
d 2* (
CAPM:
N ( d 2 ), d 2
N ( d 2* ), d 2*
r) T /
Pr[ A* (T )
Pr[ A(T )
ln A0 / KT
KT ]
KT ]
/ 2)T
T
ln A0 / KT
(r
/ 2)T
QT
N N 1 ( EDFT )
127
Xj
N 1 ( PD )
Hence
PD
Q j (1)
128
Vasiceks Formula
Let us decompose the X to a systematic
and an idiosyncratic part and express
the PD conditional on systematic
variable X j
M
1
Zj
PD1 (m)
Pr
Pr Z j
Pr T j
1| M
M 1
Zj
N 1 ( PD)
Pr X j
N 1 ( PD) | M
m
N 1 ( PD) | M
N 1 ( PD)
1
129
Vasiceks Formula
So the unexpected default rate on a
given probability level 1
is
UDR ( PD)
N 1 ( PD)
N 1( )
1
(UDR99.9% ( PD ) PD )LGDMA
RWA
EADw, w
K 12.5
0.24
50 PD
1 e
50
50
1 ( M 2.5)b
, b (0.1182 0.05478ln PD)2
1 1.5b
131
Basel II Problems
132
European Social Fund Prague & EU: Supporting Your Future
Basel III ?!
Recent BCBS proposals reacting to the crisis
Principles for Sound Liquidity Risk
Management and Supervision (9/2008)
International framework for liquidity risk
measurement, standards and monitoring consultative document (12/2009)
Consultative proposals to strengthen the
resilience of the banking sector announced
by the Basel Committee (12/2009)
133
European Social Fund Prague & EU: Supporting Your Future
Basel III ?!
Comments could be sent by 16/4/2010 (viz
www.bis.org)
Final decision approved 12/2010
Key elements
Stronger Tier 1 capital
Higher capital requirements on counterparty risk
Penalization for high leverage and complex
models dependence
Counter-cyclical capital requirement
Provisioning based on expected losses
Minimum liquidity requirements
134
European Social Fund Prague & EU: Supporting Your Future
Content
Introduction
Credit Risk Management
Rating and Scoring Systems
Portfolio Credit Risk Modeling
Credit Derivatives
135
European Social Fund Prague & EU: Supporting Your Future
Credit Derivatives
Payoff depends on creditworthiness of
one or more subjects
Single name or multi-name
Credit Default Swaps, Total Return
Swaps, Asset Backed Securities,
Collateralized Debt Obligations
Banks typical buyers of credit
protection, insurance companies
sellers
136
European Social Fund Prague & EU: Supporting Your Future
Billion USD
60 000
50 000
40 000
30 000
20 000
10 000
CDS Notional
137
European Social Fund Prague & EU: Supporting Your Future
138
European Social Fund Prague & EU: Supporting Your Future
Valuation of CDS
Requires risk neutral probabilities of
default for all relevant maturities
Market value of a CDS position is then
based on the general formula
n
MV
rT
i i
EQ [cash flow i ]
i 1
Estimating Default
Probabilities
Rating systems
Historical PDs
Bond prices
CDS Spreads
140
European Social Fund Prague & EU: Supporting Your Future
Credit Indices
In principle averages of single name CDS
spreads for a list of companies
In practice traded multi-name CDS
CDX NA IG 125 investment grade
companies in N.America
iTraxx Europe - 125 investment grade
European companies
Standardized payment dates, maturities
(3,5,7,10), and even coupons market value
initial settlement
141
European Social Fund Prague & EU: Supporting Your Future
143
European Social Fund Prague & EU: Supporting Your Future
144
European Social Fund Prague & EU: Supporting Your Future
CDO market
Global CDO Issuance
600
Billion USD
500
400
300
200
100
0
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010E
Total
Year
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
High Yield
Bonds
11 321
13 434
2 401
10 091
8 019
1 413
941
2 151
Other
932
2 705
9 418
6 947
14 873
15 811
14 447
1 722
Other
Swaps
110
6 775
2 257
762
1 147
Structured
Finance
1 038
794
17 499
35 106
83 262
157 572
307 705
259 184
18 442
331
Total
67 988
78 454
83 074
86 630
157 821
251 265
520 645
481 601
61 887
4 336
145
European Social Fund Prague & EU: Supporting Your Future
146
European Social Fund Prague & EU: Supporting Your Future
Valuation of CDOs
Sources of uncertainty: times of default
of individual obligor and the recovery
rates (assumed deterministic in a
simplified approach)
Everything else depends on the
Waterfall rules (but in practice often
very complex to implement precisely)
148
European Social Fund Prague & EU: Supporting Your Future
Valuation of CDOs
Monte Carlo simulation approach:
In one run simulate the times to default of
individual obligors in the portfolio using risk
neutral probabilities and appropriate
correlation structure
Generate the overall cash flow (interest and
principal payments) and the cash flows to
individual tranches
Calculate for each tranche the mean
(expected value) of the discounted cash flows
149
European Social Fund Prague & EU: Supporting Your Future
Zj
Implied Correlation
Correlations implied by market quotes
based on the standard one factor model
(similarly to implied volatility)
Alternative Models
The correlations are uncertain!
The Gaussian correlations may go up if there
is a turmoil on the market!
Alternative copulas: Student t copula, Clayton
copula, Archimedean copula, Marshall-Olkin
copula
Random factor loading
Dynamic models stochastic modeling of
portfolio loss over time structural (assets),
reduced form (hazard rates), top down
models (total loss)
152
European Social Fund Prague & EU: Supporting Your Future