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SourcesofrisksMarketRiskFebruary8,20102CreditRiskOperationalRiskReputationRiskFISourcesofrisksMarketRiskFebruary8,20102CreditRiskOperationalRiskReputationRiskFI
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IncreasedimportanceofCreditRiskMarketconditionsRegulatoryrequirementsimpactofBasleAccords;
primarilyBasleIIFebruary8,20103IncreasedimportanceofCreditRiskMarketconditionsRegulatoryrequirementsimpactofBasleAccords;primarilyBasleIIFebruary8,20103
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BasisofCreditRiskManagementTheoreticallyavoidablepracticallyonehastolivewithitAppropriatemeasurement
MitigationFebruary8,20104BasisofCreditRiskManagementTheoreticallyavoidablepracticallyonehastolivewithitAppropriatemeasurementMitigationFebruary8,20104
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SeparationofRiskManagement&Lending
RiskManagement
.Responsiblefordevelopingacredit
strategy&approvingallcreditrisks.Responsibleforongoingmonitoringofa
clientscreditworthiness&creditexposure.Establishesandmaintainscreditratings.DeterminescredittermsandconditionsLendingGroups
.Responsibleformanaging
clientrelationships.
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Marketloanproductsloanproducts.Market
.Originate,structureandexecutetransactionsFebruary8,2010
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CreditRiskManagement-Objectives
.Atthetransactionlevel.Establishanappropriatecreditrisk
environment.Operateunderasoundcreditapprovalprocess.Maintainanappropriate
creditadministration,measurementandmonitoringprocesssophisticatedtools/techniquestoenablecontinuous
.EmployEmploysophisticatedtools/techniquestoenablecontinuousriskevaluationona
scientificbasis
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.Adequatepricingtooptimizerisk-return
relationship.Attheportfoliolevel.Developmethodologiesandnormsto
evaluateandmitigaterisksarisingfromconcentrationbyindustry,groupetc..Ensure
adherencetoregulatoryguidelines.DriveassetgrowthstrategyFebruary8,2010
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CreditRiskManagementRequirementsMeetthedraftBISguidelinesincreditriskmanagementFebruary8,20108MeettherequirementsstipulatedintheRBIguidelinesforriskmanagementsystemsinbanks
MeetinternallimitsCreditRiskManagementRequirementsMeetthedraftBISguidelinesincreditriskmanagementFebruary8,20108MeettherequirementsstipulatedintheRBIguidelinesforriskmanagementsystemsinbanksMeetinternallimits
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ageneralpurposeevaluationoftheevaluation
oftheborrower
.Notaonetimeassessmentof
creditworthinessoftheborrower.Notnecessarilyco-relatedtoEquitymarkets/
SharePriceetc.February8,2010
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CreditRatingFramework
.CreditRating:Anopiniononabilityandwillingnesstopayin
fullandintimelymannerallfinancialobligations.Theproposedanalyticalframework
dividesvariousissuesthatimpactcreditriskintoseparatecategories.Ensurescomprehensivenessallrelevantissuesarecovered.Ensuresstandardizationandcomparability-increases
consistency.Enables
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bettercommunicationButframeworkhastobe
usedonlyasabroadguidelineandnotrigidly.Casespecificissues
needmodificationinparametersandrelativeimportanceofthevariouselements.
February8,2010
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CreditRatingFramework
.Ability:Riskofcashgenerationandextentofobligationsthathave
tobemetfromthesecashflows.Cashgenerationabilityinturn
dependsupon.Macro:Economyandindustryrisk.Micro:Companyscompetitivepositionintheindustry.MarketpositionRevenuegenerationriskPrice
&volumerisk
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.OperatingefficiencyCostandproduction
risk.Extentofobligation:MeasuredbyFinancialRisk(Liabilitysidefocus)
.Fullandtimely:Financialflexibilityandcashflowadequacy.Willingness:An
indexofManagementRisk.Alltheseelementsdeterminethestandalonecreditquality..Further,ifthecompanyisowned/partofastrongparent/
group,itcan
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Whatshouldbedone
.Buildingabottom-upviewofthebusiness.Silo
approachinconceptlargenumberofinterlinkagesinpractice.Natureand
strengthofsuchinterlinkagesiskeytoappreciatingbusinessdynamicsgy
yppinthiscontext,thekeyquestionstoconsiderare:
.Where
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isthecompanytoday?.Whattargets
havetheysetthemselves?.Whatstrategywilltheyadopttoachieve
it?.Howwilltheexternalenvironmentrespond?.Howhasmanagementresponded
totheenvironmentinthepast?Whatwilltheydonow?February8,2010
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Banksvs.CreditRatingAgencies
.CRAsusecashflowbasedassessments.Banksmayusesecurity
basedassessments.CRAscarryoutcashflowprojections/sensitivities.Banksmay
dolikewisebasedoncompanyprojections.CRAsassessunderlyingsecurityonlyasanadditionalassessunderlyingsecurityonlyasanadditional.CRAsfactor
(tonotch
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up)
.Banksuseunderlying
securitycentrally.Banksmayusetimelypaymenthistorycentrally.CRAs
usetimelypaymenthistoryonlyasahygienefactor.Typically,CRAsfocus
mainlyonassessingProbabilityofDefault.BanksfocusonassessingexpectedlossesFebruary8,2010
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PDvs.ELApproach
.PDApproach.PDapproachfocusesonlyontimelypayments.
PDismorerelevantatismorerelevantat.PDhigherrating
levels
.Recoveryprospectsmaybeaddressedinseparatescale.ELApproach.ELapproachfactorsinrecoveryfromunderlyingsecurityand
othercreditenhancements
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.ELismorerelevantatlower
ratinglevels.OnescaleaddressesbothPDandELFebruary8,
2010
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Cashflowsvs.ProfitsProfitscanmaskpotentialproblemsinanaccrualbasedapproach
Futurecashgenerationfromthebiilldbfibusinesswillrepaydebt,notprofitsBusinesscashflowshavetobeunderstoodinthecontextof:MaturingdebtobligationsFuturecapitalexpenditurerequirementsWorkingcapitalneedstosupportgrowthFebruary8,201015Cashflowsvs.Profits
ProfitscanmaskpotentialproblemsinanaccrualbasedapproachFuturecashgenerationfromthebiilldbfibusinesswillrepaydebt,notprofitsBusinesscashflowshavetobeunderstoodinthecontextof:MaturingdebtobligationsFuturecapitalexpenditurerequirements
WorkingcapitalneedstosupportgrowthFebruary8,201015
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DefaultRates
.Indicates
theprobabilityofdefault(PD)foragivenratingovera
givenperiodoftime.E.g.Aratinghasa3.8%PD
over2years.Eachratinghasastringofprobabilityoveritslife.E.g.0.9%in1-year,3.8%in2-yrs,7.8%in3
yrs,andso
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on.ThTheparadoxofone
instrumentover1000instrumentsdfitt1000it
.Forsingleinvestment,investorcaneithergethismoneyornot!(Binary)
.Butifheholds1000investmentsofsamerating,9or38maydefault(9correspondsto1yeardefaultand38corresponds
toa2
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yeardefault).Distinctionisimportantfor
severalcriteria,particularlyinstructuredfinanceFebruary8,2010
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TransitionRates
.Indicates
probabilityoftransitionfromoneratingtoanotheroveragivenperiod
oftime.E.g.ProbabilityofAAAmovingtoAA
over1-yearis3.5%.ProbabilityProbabilityofanyratingmovingtoofanyratingmovingtoDoveragivenagiven
.Dover
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ORAFrameworkOverallRiskAssessmentsheetcapturesallthefactorsthatinfluencethebusinessrisk,financialriskassessmentinaconcisemannerassessmentinaconcisemannerEnablesa
snapshotappreciationofallinterlinkagesFebruary8,201018ORAFrameworkOverallRiskAssessmentsheetcapturesallthefactorsthatinfluencethebusinessrisk,financialriskassessmentinaconcisemannerassessmentinaconcisemannerEnablesasnapshotappreciationofallinterlinkagesFebruary8,201018
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CreditRiskManagement:Existing
.HistoricalApproaches:.PrudentialexposuresnormsIndividual,group,and,Industry
wise.MeasurementofriskthroughCreditRating/CreditScoring.Emphasis
oncollaterals.Loanreviewmechanism.Pii:StddidhProvisions:Standardizedapproach
.Riskcapital:Standardized
approach.Newer
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Approaches:.Quantificationofrisk(bothborrower
andfacility).Riskpricing(andpartlythroughHedging).Portfolio
approach:Estimatingexpectedloanlossesandunexpectedloanlosses.Estimatingcapitalrequirements
February8,2010
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IRBframework:Keyelements
.Riskcomponents:estimatesriskparametersprovidedbybankssomeofwhich
aresupervisoryestimates.Riskweightfunctions:riskcomponentsaretransformedinto
riskweightedassetstransformedintoriskweightedassets
.Minimumrequirements:minimumstandardsthatmustbemetinorderforabank
tousethe
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IRBapproachforagivenassetclass.
February8,2010
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RiskweightfunctionsCorrelation(R)0.12*(1-exp(-50*pd)
)/(1-exp(-50))+0.24*(1-(
1-exp(-50*PD))/(1-exp(-50))Maturityadjustment(
b)(0.11852-0.05478*ln(PD))^2(0.118520.05478ln(PD))2Capitalrequirement(K)LGD*N((1-R)^0.5*G(PD)+(R/(1-
R))^
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0.5*G(0.999))-PD*LGD)*(
1-1.15*b)^-1*(+(M-2.5)*b)RiskweightedAssets(RWA)
K*12.5*EADFebruary8,201023RiskweightfunctionsCorrelation(R)0.12*(1-exp(-50*pd))/(1-exp(-50)
)+0.24*(1-(1-exp(-50*PD))/(1-exp(-50))Maturityadjustment(b)(0.11852-0.05478*ln(PD))^
2(0.118520.05478ln(PD)
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)2Capitalrequirement(K)LGD*N((1-R)
^0.5*G(PD)+(R/(1-R))^0.5*G(
0.999))-PD*LGD)*(1-1.15*b)^-1*(+(
M-2.5)*b)RiskweightedAssets(RWA)K*12.5*EADFebruary8,201023
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CreditScoringModelsLinearprobabilitymodelandlogitmodelLinearDiscriminantanalysis:AltmansZ-
scoreFebruary8,201024CreditScoringModelsLinearprobabilitymodelandlogitmodelLinearDiscriminantanalysis:AltmansZ-scoreFebruary8,201024
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CreditRatingSystemsExternalcreditratingsInternalcreditratingsystemFebruary8,201026CreditRatingSystems
ExternalcreditratingsInternalcreditratingsystemFebruary8,201026
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ExternalRatings
.Internationally
S&P,andMoodysareprovidingtheseservices.Theyratebothfinancialinstruments
andcompanies..InIndia,CRISIL,ICRA,CAREandFitcharetheexternal
creditratingagencies..Ratingisaprocessofcategorizingcompaniesandinstrumentsintodiscreteratingcategoriesthatcorrespondtotheestimatedlikelihoodofthe
companyfailingto
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RatingIssues
.Solicited
rating:Acompanyapproachestheratingagencyforratingofeitherinstrument
orthecompany.Ratingisbasedonbothpubliclyavailableinformationandthe
privilegedinformation.Unsolicitedrating:Ratingonthebasisofpurelypublishedinformationanddisclosingitinthepublicinterestinformationanddisclosingitinthe
publicinterest.
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Issuercreditrating:Theratingisan
opinionontheobligorsoverallcapacitytomeetitsfinancialobligations.The
opinionisnotspecifictoanyparticularliabilityofthecompanynordoes
itconsiderthemeritsofhavingguarantorsforsomeoftheobligations.Counterpartyratings,corporatecreditratings,andsovereigncreditratingsarepartof
issuercreditratings.
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.
February8,2010
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RatingIssues
.Issue
SpecificCreditRating:Theratingagencydistinguishesfinancialinstrumentsintoshortterm
andlongterm..Theratingprocessincludesquantitative,qualitative,andlegalanalyses.
.Thequantitativeanalysisismainlyfinancialanalysisandisbasedonthefirmsfinancialreports..Thequalitativeanalysisisconcernedwiththequality
ofmanagement,and
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AssignAnalyticalTeamConductBasicResearchMeetIssuerRatingCommitteeMeetingIssueRatingSurveillanceRequestforRatingAssignAnalyticalTeamConductBasicResearchMeetIssuerRatingCommitteeMeetingIssueRatingSurveillanceReque
stforRatingStandardandPoorsDebtRatingProcess
Source:CrouhyMichael,
DanGalai,RobertMark(2001),RiskManagement,,McGraw-Hill
February8,
2010
31
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InternalRatingSystems
.
Aninternalratingreferstoasummaryindicatorofriskinherentin
anindividualcredit.Ratingstypicallyembodyanassessmentoftheriskofloss
duetofailurebygivenborrowertopayaspromised,basedonconsiderationofrelevantcounterpartyandfacilitycharacteristics..Aratingsystemincludes
theconceptualmethodology,
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managementprocesses,andsystemsthatplaya
roleintheassignmentofrating..BorrowerVsFacilityRating:Borrower
ratingfacilitiesestimationofProbabilityofDefault(PD),whereasfacilityratingor
transactionratingfacilitatesestimationofLossGivenDefault(LGD)also..PointinTimeorThroughtheCycleapproach:PointinTimeis
ratingonthe
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basisofborrowercurrentconditions.Underthrough
thecycleapproachborrowersexpectedconditioninadownwardeventisprimarily
considered.ThroughtheCycleapproachmaybeappropriateforlongtermloans.February
8,2010
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RiskFactors
.Financial
risk:Analysisoffinancialstatementsandcalculationofvariousratios.Industry
risk:Competition,technology,exportpotential,barrierstoentry,productcharacteristicsetc.Management
risk:Professionalexperienceofmanagement,Labourrelations,Professionalqualificationsofmanagement,financialdisciplineofborrowers,CorporategovernanceetcFebruary8,2010
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RiskGrades
.Grades
areaneffectivewayofexpressingdifferentiationofriskcategorizationofentire
loanportfolio..Differentiationofriskandloanpricingareintimatelyrelatedand
alsohelpfulinfixationofexposurenorms..Somegradesmaybecategorizedaspassgradesandygpggsomemaybecategorized
aswatchingcategory
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.Largenumberofgrades
ontheratingscaleisexpensivetooperate.Frequencyoflegitimatedisagreements
aboutratingsislikelytobehigherwhenratingsystemshavelargenumber
ofgradesFebruary8,2010
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HowtoImprovetheQualityof
LoanPortfolio:OpportunitiesforAction
.Choosetherightrisk
indicators.Accuracy.Abilitytoincludeallrisks.Dataavailabilityand
quality.Relevance.Refinethetraditionalcreditratingprocess.FinancialAnalysis.IndustryAnalysis:Aforwardlookingperspective.AuditsandInspectionsto
refinequantitativeanalysis
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.Finetuningfordowngrades.
Gradingthecustomerforpricingandriskmanagement.Compromisingwiththe
creditratingsystem.Improvetheskillsoflinecreditofficers.Validate
thecreditmanual.Tightenthecontroloverthedecisionmakingprocess.Enforcethetrueriskbasedpricing.Introducesimpleboardlevelrisk
reportsfornon-risk
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expertsFebruary8,2010
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CreditScoringModelsFebruary8,201036CreditScoringModelsFebruary8,201036
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LinearProbabilityModel
.
TheLinearprobabilitymodelusespastdatasuchasfinancialratios,as
inputsintoamodeltoexplainrepaymentexperienceonoldloans..
Loansaredividedintotwoobservationalgroups:thosethatdefaultedandthosethatdidgroups:thosethatdefaultedandthosethatdidnotdefault.
.
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Relatetheseobservationsbylinearregressionto
asetofcasualvariablesthatreflectquantitativeinformationabouttheborrower
suchasleverage.February8,2010
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1LogistictransformationofthevalueofPDarrivedinthelinearprobitmodelbypluggingthePDintothefollowingformulaPDiiePDF-+=11)(February8,2010391LogistictransformationofthevalueofPDarrivedinthelinearprobitmod
elbypluggingthePDintothefollowingformulaPDiiePDF-+=11)(February8,201039
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TheLogitModelThemodelfitsY=V+WX+
errortermYhavingaspecificcategoricalvalueas:as:P(Y)=1/((1+exp(
-Y))LogisticProbabilityDistributionFebruary8,201040TheLogitModelThemodelfitsY=V+WX+errortermYhavingaspecificcategoricalvalueas:
as:P(Y)=1/((1+exp(-Y))
LogisticProbabilityDistributionFebruary8,201040
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TheProbitModelP(Y)=cdf(Y)
=cdf(Y=V+WX+error)IfCDFis1.55meanstheP(Y)=93.94%
withthecumulativeStandardisednormaldistributionnormaldistributionFebruary8,201041TheProbitModelP(Y)=cdf(Y)=cdf(Y=V+WX+
error)IfCDFis1.55meanstheP(Y)=93.94%withthecumulativeStandardisednormaldistributionnormaldistributionFebruary8,201041
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Linear-DiscriminantModel:AltmansOriginalEquationZ=1.2x1+1.4X2+
3.3X3+0.6X4+1.0X5X=WC/TAX1WC/
TAX2=RE/TAX3=EBIT/TAX4=MVofEquity/BVofLiabilities
X5=Sales/TAFebruary8,201042Linear-DiscriminantModel:AltmansOriginalEquationZ=1.2x1+1.4X2+3.3X3+0.6X4+1.0X5X=WC/TAX1WC/TAX2=RE/
TAX3=
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EBIT/TAX4=MVofEquity/BVofLiabilitiesX
5=Sales/TAFebruary8,201042
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Firmswithhighscores(orabovecut-offvalue)ofZcouldbeclassifiedasnon-defaultersandwithlowZscoresasdefaulters.
Classificationproceedswithfunctionsthatgeneratestheprobabilityofbeinginagivengroupbasedonthescorevalue.February8,201043Firmswithhighscores(orabovecut-offvalue)ofZcouldbeclassifiedasnon-defaultersandwithlowZscoresasdefaulters.Classificationproceedswithfunctionsthatgeneratestheprobabilityofbeinginagivengro
upbasedonthescorevalue.February8,201043
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ROCCurve
.The
RecoveryOperatingCharacteristic(ROC)AccuracyRatioiscomputedbycomparingthe
pairs.Theaccuracyratioistherelationshipbetweenallpossiblepointsandthe
maximumbfithihiltthtt
numberofpointswhichisequaltothetotallnumberof
samplepoints.
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.Amodelwhichhasthe
highestROCscoreisconsideredasthebestmodelamongothers
February8,2010
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Estimating PDsScores arrived in this process can be transformed in toposterior probabilities which makes the model as defaultprediction model. Here finding the default probability isconditional score Zgreater than the value zobtainedfor a particular firm. With the help of Bayes theorem
conditional (a priori probability) probabilities can beconverted in to conditional posterior probabilities.February 8, 2010 45
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C re d i t Ri s kM o d e l s46CreditRiskModels46
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TermStructureApproachRiskpremiumsareinherentincurrentstructureofyieldsoncorporatedebt.Thisgivesexpecteddefaultratesfromthecurrenttermstructureofinterestrates.
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-cyyf111*11fisrecoveryrateyisyieldonTreasurySecurityYcisyieldonCorporatebondFebruary8,201048TermStructureApproachRiskpremiumsareinherentincurrentstructureofyieldsoncorporatedebt.
Thisgivesexpecteddefaultratesfromthecurrenttermstructureofinterestrates.
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---
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-cyyf111*11fisrecoveryrateyisyieldonTreasurySecurityYcisyieldonCorporatebondFebruary8,201048
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LimitationsListedcorporatebondsareveryfewPoorliquidityofcorporatebondsFebruary8,201049Limitations
ListedcorporatebondsareveryfewPoorliquidityofcorporatebondsFebruary8,201049
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MortalityRateDerivationofCreditRisk
.DefaultprobabilitiesarederivedfromMarginalMortalityRate(
MMR)..MMRofYear1=TotalvalueofgradeA
bondsdefaultinginyear1ofIssue/TotalvalueofgradeBbondsoutstandinginyear2ofissue.Itproduceshistoricor
backwardlooking..
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Implieddefaultprobabilitiesmaybehighlysensitive
totheselectedperiod.February8,2010
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publiclytraded.(example:CreditMetricsTM).
This
approachalsocalledasVaRapproach
February
8,2010
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ComponentsrequiredAvailabledataonaborrowerscreditratingRatingtransitionmatrix
RecoveryratesondefaultedloansYieldspreadsinthebondmarketpFebruary8,201052ComponentsrequiredAvailabledataonaborrowerscreditratingRatingtransitionmatrixRecoveryratesondefaultedloansYieldspreadsinthebondmarketpFebruary8,201052
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Mark-toMarketApproach
.
Acreditlosscanariseinresponsetodeteriorationinanassets
creditquality..TheMTMapproachtreatsthecreditportfolioisbeingmarked
tomarketatthebeginningandendoftheplanninghorizon.Creditlossisthedifferencebetweenthesevaluations.Thesemodelsmustalso
incorporatecreditrating
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ProblemsinApplicationofVaRtoloansMarketValueofLoansarenotavailableasloansarenotnon-tradableNotimeseriestocalculatethevolatility(Y)
NormalDistributionisroughapproximationFebruary8,201054ProblemsinApplicationofVaRtoloansMarketValueofLoansarenotavailableasloansarenotnon-tradableNotimeseriestocalculatethevolatility(Y)NormalDistributionisroughapproximationFebruary8,201054
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Thuscreditriskexistsaslongas
thePr.(VT0(probabilityofdefault).ThisThisimplies
thatattime0,Bimpliesthatattime0B0
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