Definition:” Credit Risk is the risk of loss arising from some credit event with counterparty”. Who can be the possible counterparty? Counterpart can be Individuals, companies or the government of a country itself. In layman’s terms credit risk is the risk that you won’t be paid back your money or the the person whom you have lended money or given money for a contract defaults. There can be many types of obligations apart from the currency such as, customer credit to financial derivative transactions. Credit risk also referred to as default risk. In this the obligator does not honor the obligation. Another important term might be credit exposure. This is also known as exposure at default. This tells how much creditor will loose if the counterparty defaulted it’s obligation What are the models of managing the credit risk? The models are based on the two important concepts: 1. Default Probability 2. Recovery Rate And combiningly they are called credit spread Different types of credit risk Issuer Risk Counterparty Risk Default Risk Creditworthiness Risk The mutual combination creates different types of credit risk which can be placed in the box.
In the absence of analytical information about a company’s financial position, many investors in corporate credit markets would stay within the confinements with a lower returns of the banks and the government securities. If investors can be eligible to compare credit risk across companies, industries and countries, the capital market will get a lot of investors in corporate bond market. Reduction or proper evaluation of Credit Risk can help investors to access funds from a various instrument as well as reduces information risk, which eventually helps in efficient pricing. This reduces the cost of capital and allows a larger number of projects to be economically possible, hence enhancing growth of economy. More the number of projects, more is the liquidity in bond market. The banking system inefficiencies are not present in capital market. Hence, proper management of credit risk is very essential in capital markets. The proper evaluation also brings transparency and reduces information asymmetry in the Capital market. By this the people get proper incentive to invest in capital market. Also BASEL II requires that credit risk to be included in the definition of the market risk.
Credit derivatives help in transferring the risk of loss in a loan, bond, derivative or other financial obligation from one party to another. They allow institutions to transfer credit risk without buying or selling the underlying asset. Even if a very damaging operational risk is hitting the bank, the credit derivatives help in dispersing the risk. Payouts on credit derivatives depend in some way on the creditworthiness of companies or countries that borrow money either via loans or the issue of bonds. The credit worthiness is recognized by various credit rating agencies. The examples might be Moody’s Investors Service or Standard & Poor’s. Credit derivatives though may not appear to have an underlying asset, can be equated to a premium paid to transfer the risk to the third party.
There are a lot of methodologies for mitigating the risks. Some of them are stock index futures, letter of credits, insurance products, hedging by forward rate agreements, swaps and lot more. But the question now is why credit derivatives are special? Yes. They are special due to the fact that they are helpful in mitigating the risk when economy is in a very bad condition. The commercial risk reducing instruments, instead of offsetting each other, combine to increase the risk in overall. Have a look at the figure below.
The credit derivative helps Transferring risk to third party Individual retail clients to invest in bonds and stocks previously unaffordable Individuals to invest in the foreign bonds with lower expenditure Indirect Investing in stock: Helpful for foreign investors who want to buy the domestic bond(Help them to bypass regulatory constraints) Reduce the risk of a start-up financing Split out the company specific risk from the market risk Some of the credit derivative instruments are mentioned below
The players in credit derivative market are divided into two groups. It is interesting to note that the same types of the firms are on the both side, namely, banks, security houses, insurance companies and hedge funds. The most prominent players are the banks and the least prominent player is government. Participation of the corporate in credit derivative market is in mid range. It is noticed that the dominance of the banks in the credit derivative market is decreasing day by day, but they still remain the prominent players. In case of Buyers, Securities Houses and Hedge Funds are in 2nd and third position respectively. Whereas, in sellers, Insurance companies and the Securities Houses are in second and third position respectively. It is a good news that the number of small players are increasing day by day and hence resulting in increase in the liquidity in the credit derivative market. What are the underlying Assets? CorpSovereign Assets(Non-Emerging Markets) Others Corporate Assets Financials Sovereign Assets(Emerging Markets) orate asset is most used underlying reference asset
Jp-to-default risk in case of Credit Default Swap: This is the risk for the seller in case of the default of reference entity. Seller has to pay millions of dollar to the buyer who is protected Bankruptcy Risk: The risk that reference entity will go bankrupt Restructuring Risk: The risk that the reference entity will be restructuredum
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