Credit Risk Modelling

Credit Risk Modelling Course Overview:

For banks and financial institutions a sea of changes has occurred in the past few years as a response to the credit crisis. A new capital adequacy framework, strengthened and specific credit risk regulations under Basel II / III, and recent innovations in the credit derivative arena are all highlighting the increasing scrutiny on credit issues. More than ever before, financial institutions and large corporates will therefore have to be able to assess, calculate and model the embedded credit risk of assets as well as the risk generated by the use of counterparties for hedging or trading purposes.

This  Credit Risk Modelling course is designed to provide professionals with a broad understanding of modern credit risk modelling techniques.  During this training programme, participants will look in details at some of the more important models used for the pricing of default risk inherent to holding  assets or embedded within credit derivatives. The focus of the course together with the choice of exercises and examples will enable participants to understand the different stepping stones used in the design of the models in an easy way and the reasons why the models can be validated.  Delegates will examine how different risk elements, such as interest rate, default and recovery values intertwine in those models.

Participants will be able to appreciate the credit models commonly used to calculate EAD (Exposure at Default), PD (Probabilities of Default) and LGD (Loss Given Default) as well as counterparty risk assessment models based on potential future exposure at default. We examine recent modelling issues of funding and market liquidity, basis risk and counterparty risk, and learn the meaning and use of the different value adjustments and notions such as wrong-way risk and liquidity issues.

Credit Risk Modelling Course Methodology

This Credit Risk Modelling course is highly interactive with presentations, exercises, examples, workshops and discussions. It is supported by a range of computer-based exercises to help delegates put the concepts covered into practice.

This course can be presented in-house via live webinar.

Who could benefit from this Credit Risk Modelling course?

  • Credit Portfolio and Asset Managers
  • Auditors
  • Risk Analysts
  • Credit Managers
  • Financial Industry Regulators
  • Financial Risk Managers

Credit Risk Modelling Course Content:

Day one

Definitions of parameters used for modelling credit risk

  • Introduction to credit risk models and their parameters
  • Credit event definition and exercise
  • Loss-Given Default (LGD), Expected Loss (EL) and probability of Default (PD)
  • Calibration of default probabilities to actual ratings
  • Exposure at default (EAD)
  • Relationship between PD, EAD, LGD
  • Unexpected Loss (UL)
  • Economic capital
  • Loss distribution
  • Monte Carlo simulation of losses
  • Recovery rate (recovery payments)

Workshop: Computation of theoretical credit spread for an amortizing asset with given LGD, PD and EAD at different maturity stages

Market based methods

  • CDS cash flows and default risk
    • Unbundling a risky bond into default and other components
    • Isolating underlying default risk using a single instrument
  • Adding floating LIBOR-based payments
    • Credit spread over swap rate
    • Default-free money market deposit – Floating Rate Note (FRN)
    • Final adjustment to compensate coupon reduction – Synthetic portfolio of cash flows
  • Real world complications and hedging difficulties
  • Counterparty default risk and liquidity

Exercise: Assessment of the credit spread value for an asset given the market perception of the underlying credit risk and CDS / bond market information

Concept of synthetic Credit Default Swap (CDS): Basis Trades

  • Hedging / arbitraging CDS: positive and negative basis trades
    • Bond and structured finance issuance
  • CDS “Fair Price”: asset swap “par” spread implications
  • CDS key issues:
    • Over the counter (OTC) shortcomings

Exercise and discussion: Using an asset swap to uncover market credit risk spreads. Unbundling the different risk component of an asset and using CDS to mitigate risks.

Day two

Structural Firm Asset Volatility Models

  • Black & Scholes / Merton Option Pricing Approach
  • Key credit risk concepts
  • Credit (default) risk as put option

Merton / KMV Model (Firm Asset Volatility Model)

  • Hybrid corporate securities. Options in corporate finance
  • Credit risk: asymmetric information and agency costs
  • Structural asset volatility (Black-Scholes / Merton) models
  • Structural asset volatility (Moody’s-KMV) models
  • Embedded complexities of interim cash flows

Workshop: How to use various financial instruments to replicate an option (Black & Scholes) synthetically. How to derive Credit Spreads from a practical point of view.

Black-Scholes / Merton KMV Option Pricing Approach

  • Credit risk as a function of equity value
  • Cost of hedging credit default risk
  • Term structure of credit default risk spread
  • Distance-to-default (DD)
  • Probability of loss-given-default (PD)

Exercise and discussion: How to price a Credit Default Swap with the use of a structural model by looking at both the premium value and protection legs.

REDUCED-FORM MODELS (BASED ON INTENSITY OR TRANSITION) Part 1

Jarrow-Turnbull (JT) Reduced-Form Intensity Model: Applying Term Structure Models

  • Stochastic term structure of default-free interest rates:
  • Markov process for credit ratings
  • Stochastic maturity specific credit-risk spread
  • Implementing a discrete-time Markov model:
    • Pricing risky bonds
    • Pricing options on risky bonds
    • Credit default swaps

Exercise: How to price a Credit Default Swap with the use of a reduced-form approach model such as JLT and appreciate the implications of credit ratings

Day three

REDUCED-FORM MODELS (BASED ON INTENSITY OR TRANSITION) Part 2

Jarrow-Lando-Turnbull (JLT) Rating-Based Transition Matrix Technology

  • Applying Jarrow-Lando-Turnbull model
    • Arbitrage-free restrictions of the model
    • A discrete-time model in a two-period economy
  • Credit ratings and default probabilities: mathematics underlying the JLT model

Workshop: How to use a reduced-form transition matrix model based spreadsheet for pricing credit derivatives.

Pricing Derivatives Contracts Under Collateral Agreements in Credit Support Annex (CSA), Credit Value Adjustment (CVA) Debt Value Adjustment (DVA), Liquidity / Funding Value Adjustments (LVA, FVA)

  • Collateral agreements
    • Collateral (initial margin)
    • Variation margin
    • Maintenance margin
  • CSA contract agreements, aggregated base, netting set, Net Present Value (NPV)

CSA Pricing: Discrete Setting

  • Cox-Ross-Rubinstein binomial risk-neutral option pricing
    • Non-collateralised contingent claims, collateralised claims, and liquidity value adjustment (LVA)
  • Liquidity value adjustment LVA: discounted NPV between risk-free rate and collateral rate

Exercise: How to assess the cost of replicating collateral account at predefined asset’s path 

Counterparty Credit Risk: Wrong Way Risk, CVA, FVA, & Liquidity Issues

  • Counterparty contract risk exposure
  • Wrong / right-way risk: CVA adjustment
  • Wrong-way risk theoretical framework
    • Expected positive exposure (EPE)
    • Default intensity (PD)
  • Credit value adjustment (CVA) of OTC derivatives
    • CDS spread (PD, LGD), EPE
  • Risk management: counterparty credit VaR
  • Credit VaR and exposure:
    • Current exposure (CE)
    • Potential future exposure (PFE)
    • Credit limits – Expected exposure (EE)
    • Expected Positive Exposure (EPE)
    • Exposure-at-default (EAD)

Workshop: Analysing the various elements of Counterparty Risk with a practical example and the hedge with a contingent credit default swaps (CCDS)

Final discussion and conclusions

Related Courses

Training Course Training Course Summary
Advanced Credit Derivatives This course gives participants the opportunity to gain a comprehensive insight into the credit derivatives
Derivatives and ISDA Course Learn about ISDA documentation with ISDA definitions and ISDA Credit Support Annexes and Credit Support Deed
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Discounts

5-6 participants – 20% discount,7-8 participants – 25% discount,Over 9 participants – 30% discount