11/30/2019

Credit Risk Analytics

Session 15

Dilip Kumar 1

Default Correlation
Loss history based simple default correlation:
In this method, we assume the correlation to be same among all
securities in a portfolio. Hence, the unexpected credit loss of the
portfolio is given as:

We can solve it for correlation.

Dilip Kumar 2

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Default Correlation
Rating based default correlation:
The correlation of default probability between two assets, i and j, can
be derived by using the following expression:

Where JDP is a joint default probability. It is the probability that loans

in both industries will default at the same time.

Di and Dj are the number of defaults in a given year t from respective

grades and Ni and Nj are the corresponding number of borrowers in
the beginning of the year in each grade.
Dilip Kumar 3

Default Correlation
Equity Correlation:
We can also take the equity correlation as a proxy of correlation.
The correlation of asset returns between two industries (X and Y) is:

• w1 and w2 are industry specific weights which can be represented either by

their respective market size or exposure size.

Dilip Kumar 4

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Credit Derivatives: Background

Limitations of Cash Credit Instruments
Assume you are a hedge fund manager who wants to go short the
credit quality of (or want to reduce your credit exposure to)
Microsoft. What are your options?
• Short the bond, assuming there was someone willing to lend it.
– Hard to find / illiquid bonds have a higher hair-cut
– Repos are typically short-term; difficult to express long-term (roll-over can be
done)
– In the event of short squeeze at maturity, could face lot of problems

Dilip Kumar 5

Credit Derivatives: Overview

Credit Derivatives are synthetic instruments that provide an alternative
source of credit exposure to cash instruments
Designed as efficient vehicles for transferring credit risk
Can be used for both investment and risk management
Credit risk is the underlying variable of a credit derivative.
Credit risk is an asset class unto itself.
By mid-90s single-name credit default swap (CDS) emerged as the
benchmark credit derivative
A credit derivative permits institutions to trade credit risk (credit (yield)
spreads, rating downgrades, defaults, any credit event). Credit risk is
traded in isolation from all other attributes that define the reference
asset. The reference asset itself is not transferred.
Dilip Kumar 6