FIN-351

Financial Risk Management

Fall 2021/2022
Credit Risk Project
Submitted by
Alia Abdelmoneim 220190022
Farah Essam 220190003
Dina Medhat 220190005
Rawan Saber 220190030

To

Dr. Mahmoud Otaify

0
 Table of Contents
Credit Risk....................................................................................................................................................2
Credit risk assessment methods:.................................................................................................................2
Quantitative methods to assess credit risk:.................................................................................................2
Expert Systems............................................................................................................................................4
References...................................................................................................................................................8

1
 Credit Risk
The likelihood of a loss arising from a borrower's failure to repay a loan or meet contractual
commitments is referred to as credit risk. Credit risk arises from credit migration, which means
the events related to changes in the credit quality of the borrower. Every corporation has its
expected bad debt which is the expected amount of credit to lose over a specific period. While
the corporate has the vision to determine the expected loss to its credit. It also has an unexpected
loss, which is the volatility of credit losses around its expected loss.

Credit risk assessment methods:

 Credit rating systems (Quantitative)
 Credit scoring systems (Quantitative)
 Expert Systems (Qualitative)
 Market based model (Banks)
Credit risk is defined by three characteristics:
1. Exposure (to a party that may default or experience a reduction in its ability to perform).
2. The possibility of this party defaulting on its obligations (the default probability).
3. The rate of recovery (how much can be rescued if a default occurs).
The greater the first two factors result in greater risk. On the other side, the higher the recovery
rate, the lower the risk. And this can be formulated as follows:
Expected loss = Exposure × Probability of default × (1 - Recovery rate).
Unexpected Loss is the average total loss over and above the expected loss. Unexpected Loss is
estimated by Value at Risk (VaR). Given that a corporation has an i, j loan, we will define the
quantities as follows:
 Li is the amount borrowed for the loan. 
 Pi is the probability of the default of the loan.
 Ri is the recovery rate of the loan.
 Pij is the correlation between losses on loan I and loan j. 
 σi is the standard deviation of loss on loan i and j 
 σp is the standard deviation of loss from the portfolio (the balance of all loans)
 α is the standard deviation of the portfolio as a fraction of the size of the portfolio.
If a loan defaults, we will calculate the loss by multiplying the default rate and LGD as follows:
Li(1-Ri). The mean of the loss is the multiplication of the probability of loss and the loss on that
loan. As of previous studies, variance is defined as: σi2= E(X2) – [E(X)]2.
We will define the X as the loss amount, σi2= E(Loss2) – [E(Loss)]2.
Therefore, we can have the rule to calculate the standard deviation for a loan as follows: 

So in order to get the standard deviation of a loan portfolio we sum the standard deviation for
each loan. As we mentioned before, alpha is the standard deviation as the percentage of the size of
the portfolio. The standard deviation that is expressed as the percentage of the size of the portfolio
is the square root of standard deviation of the loan portfolio from the losses on each loan divided
by the sum of all the loans.
2
 Quantitative methods to assess credit risk:
Rating systems: where a company's credit quality is classified into a group of cases that are all
assessed to be of the same creditworthiness. The analytic approach is determined in terms of
financial data and accounting relationships that, when combined, provide a picture of the entity's
credit ratings.
Credit scoring models: when all credits are analyzed using the same data and technique in these
scoring models, provide a grading system in a more systemic and mathematical or statistical
manner.
The following is an illustration of the credit decision:

This comprises deciding whether to (A) provide credit, which gives a benefit but also carries a
risk, or (B) refuse credit.
The need is to balance the benefits of taking a credit risk by granting credit against the risk of
losing money.
The probability that the credit defaults is expressed as (ρ). Only two outcomes are possible:
either the credit performs as expected or the credit defaults. If the credit defaults, the credit
manager will be charged the cost of what was not given, or the replacement value.
One approach to assess the risk is to work out the payoffs from the choices facing the firm.

Simple Model

Rev=70,000
P= (70,000-50,000)=
A firm ABC sell If things go as
20,000 If default occurs,
products to planned, the the customer
customer Z on customer will pay
credit , the cost is 70,000 to the firm. won’t pay.
50,000

Cost=50,000 Cost= - 50,000

3
 The situations are:
Extend credit: PV (Revenue - Costs) × (1- ρ) - PV(Cost) × ρ.
Refuse credit: 0

Credit Risk Assessing Case:

If the company earns a margin of 20 per cent on sales, and the cost is 100 then it will break even;
that is, it will be indifferent towards extending credit or refusing credit if:
PV (Revenue - Costs) × (1- ρ) - PV(Cost) × ρ = 0
PV (20) × (1- ρ) - PV (100) × ρ = 0
20-20 ρ = 100 ρ
20 = 120 ρ
Ρ = 20/120 = 0.167

So, with a likelihood of loss of 0.167, the firm is unconcerned whether to accept or reject a credit
risk. If the firm is risk adverse, it will require a positive expected return to compensate it for
taking risks. The company has two options for increasing sales while avoiding credit losses.
First, if its margin is greater, it can be unconcerned about higher losses. If the margin were 30
per cent, then it would be indifferent at a loss probability of 0.23. However, with a
loss probability of 0.2, the business can be indifferent if it can lower its loss given default, say to
80 instead of 100.
The cumulative default history for rated firms is shown in Table 1.1 over time. Because of the
size bias, these ratings are only applicable to large, publicly listed firms and their securities, and
hence may not be representative of the corporate sector as a whole. It demonstrates that credit
risk rises with time and is inversely proportional to the obligor's creditworthiness.

Rating Migration Matrix

It gives the probability of a firm ending up in a certain rating category at some point in the future,
given a specific starting point using historical data. It displays the tendency of firms in a given
class to change credit ratings.
If the credit rating is raised, it is
called an 'upgrade,' and if the
credit rating is dropped, it is called
a 'downgrade.'

4
Simple matrix to illustrate:

Suppose that, we need to estimate the probability that B bond will default over two years:
We calculate the probabilities as shown,

(1) Prob. %5 and 0 % = %5 ×0% =

0

OR
(2) Prob. %5 and 85 % = %5 ×85% = 4.25%
OR

(3) Prob. %5 and 20 % = %5 ×20% = 1%

OR

Final Prob. = (1) +(2) +(3) +(4)

Prob .=5 %+0 % + 4 ⋅ 25 %+1 %=10.25 %

5
Different rating agencies and their classifications:

Expert Systems
Expert systems or qualitative models are based on subjective judgments of what makes excellent
and bad credit quality, with the 5Cs of credit being a common example. The five 5C's of credit is
a technique used by creditors to gauge the creditworthiness of borrowers. The approach
considers five borrower characteristics and credit terms in an attempt to predict the likelihood of
default and, as a result, the lender's risk of financial loss. The 5C’s of credit include character,
capacity, collateral, capital, and condition. Furthermore, there is an argument of a 6th C, the
compliance.
Management, relationship, credit history, good corporate governance (GCG), behavior, and inn
ovation are all part of the character aspect. Liquidity, profitability ratio, indebtedness degree, pay
back history, activity ratio, financial growth, and expense ratio are all part of the capacity aspect.
The capital aspect is represented by a single metric, capital structure. External PESTEL factors,
industry, and the monitoring scope of a region make up the conditioning aspect. One indicator,
which is a guarantee, makes up the collateral aspect. All of these indications will be a basic
determinant of factors used to assess a borrower's credit risk quality.
Character
The character is the most crucial factor for the borrower's assessment. Character attributes such
as honesty, reasonableness, acumen, industriousness, integrity, attitude, and commitment are
appraised for credit. Because it constantly involves human conduct, granting a loan is inevitably
linked to character. Borrowers’ character can be depicted in two ways:
a. The affairs between the borrower and the creditor.
b. Using cash for the agreed purpose
6
Variables of character aspect:
1) Management Behavior documents credit history, incidents, integrity, and transparency in
obtaining credits.
2) Credit History includes the payment behavior of borrowers, default rate, borrowing from
other institutions, repayment history, and amount of loan repaid and borrowed.
3) Management as management experience, management education, and the firm age.
4) Good Corporate Governance contains business lawfulness of the borrowers, audited or
non-audited financial statement, and the documentation process within the operation.
5) Innovation as the higher capacity to make innovations, the lower credit risk the
borrowers will have.
6) Loan Purpose means the main goal in obtaining the credits.
7) The relationship aspect means how good relationship of the borrowers with creditors.
Capacity
Capacity refers not only to a borrower's legal ability to engage into a contract, but also to a comp
any's ability to create sufficient cash flows to repay the loan. In the context of crediting, offering
a consistent high profit in financial data is insufficient to meet the capacity need. Profit does not
necessarily reflect favorable cash flow growth. Sales or revenues for businesses are frequently
made on account, causing a delay in cash flow. Therefore, the company should make deep
analysis including the following variables:
1) Liquidity as current liquidity, quick and current ratio, and net cash cycle.
2) Profitability Ratios as profit margin ratios, return on asset (ROA) and return on equity
(ROE).
3) Indebtedness Degree as coverage ratio, debt-to-EBITDA ratio, and debt-to-asset ratio.
4) Repayment History as repayment punctuality, clarity of payment source, and repayment
capacity.
5) Activity Ratio as receivable collection period, total asset turnover, and payable turnover.
6) Expense Ratio In a common-size income statement, the expense ratio is a component of
profitability measurement. An income statement with a common-size format is one in
which each item is expressed as a percentage of sales. The expense ratio, on the other
hand, is calculated from the standpoint of expenses incurred during the financial period.
7) Financial Growth, which includes sales growth, EBIT growth, operating income growth,
payroll growth, and earning trends.
Capital
Capital refers to a company's net worth, which gives it the ability to withstand unexpected losses.
The quantity of capital invested by the proprietor in the operation also demonstrates his or her de
dication to running the business. Capital Structure is a variable that is used to show the rate of cr
edit risk in the capital aspect.
The variable includes:

1) Debt to Equity ratio

2) Equity to assets ratio
7
Condition
Condition refers to the external environment factors that affect the business. The external factors
are included in the PESTLE analysis. They are Political, Economic, Sociocultural,
Technological, Legal, and Ecological dimensions. In addition to PESTLE, the conditions include
industry analysis and region among the creditor and debtor.

Collateral
Collateral is the asset or security that the borrower pledge. In the event that a borrower is unable
to repay their loan, collateral will play a critical part in resolving the default. The collateral
should be liquid, which means that it should be easy to sell and convert to cash. As a result, the
higher the quality of collateral, the easier it is to convert it to cash.
The guaranteed variable includes quality of guarantee, presence of guarantor, and the value of
guarantee.

Example on 5Cs:
Since that companies have various credit ratings, therefore the impact on their business will
surely differ from one company to another. In order to observe these differences, two companies
with different credit ratings were chosen, which are Johnson & Johnson, the pharmaceutical
company, and Dell, the computer company. J&J has the highest credit rating which is AAA,
while Dell has BB+ which is a non-investment grade. According to the 5Cs of credit rating,
Liquidity, Indebtedness degree, Profitability ratio, and financial growth were used to compare
8
 the two companies. As for the liquidity, the quick and current ratios were applied.

The following table shows some ratios for Johnson & Johnson Company and Dell. These ratios
are used in the assessment of the creditworthiness of a company. After calculations on excel, we
conclude that the current and quick ratios of J&J are higher than that of Dell, this means the
ability of J&J to meet its financial obligations is more than Dell. The indebtedness degree
measurement was applied through debt-equity ratio, debt to asset ratio, and interest coverage
ratio.
For 2020 J&J Dell
Debt-equity ratio 0.5 5.51
Current ratio 1.2 0.80
Quick ratio 1.0 0.74
ROA 10% 3%
Interest coverage ratio 83.1 2.4

For 2020, J&J had an interest coverage ratio of 83 times. This is a very high number that means
J&J can afford to pay its interest 83 times. However, Dell has an interest coverage ratio of 2.4
times. In this case, creditors of Dell will fear that in any bad year, this ratio may fall, and Dell
may not be able to cover its obligations. Same for the Debt-to-Equity ratio, for J&J, it is 0.5,
which means that equity is double the debt, but for Dell, it is 5.5 and the majority of the assets are
funded through debt. The ROA (return on assets) and ROE (return on equity) were used to
measure the profitability ratio. The ROA of J&J was 10% and is higher than that of Dell, 3%.
This refers to how well J&J's investments generate value in making it an important measure of a
company’s productivity. Finally, the financial growth was measured using Sales growth which
measures the ability of the sales to increase over a fixed period.

These are simple examples that show us why a company has a AAA rating, and another
company has a BB+ rating. Definitely, a lot of variables constitute the decision, but these are
only models.

How do expert software systems operate?

An expert system is a software system to assess the creditworthiness of a customer. It tries

to find solutions for a problem with givens and inputs. For example, a problem may be to figure
out if a customer would default on payment. The expert system has three components:

1- A knowledge base that includes a database for rules, measures, and facts. It operates by IF-them
statements. For instance, the system compares the inputs with the rules already set on the software.
For example, if we set that the current ratio must be at least equal to 1. If the customer's ratio is 1
or greater than 1, then the system will proceed, and if not, then the customer does not meet the
criteria.
2- The working memory of the system that encompasses information about the problem.
3- The inferential system, which is the system's brain, uses the rules and facts to answer the
inquired question.

9
An example of the inference chain is given in the chart below. If we said that Z is the bond default,
which is the objective to know. Y is cash flow, D is corporate governance score, X is the revenue,
and B is expenses. A can be any decision related to operations that affect sales revenue as a
marketing campaign.

We want to assess this

company, so we use the
expert system to see
the impact on our final
objective, which is bond
defaults. The system
operates in the following
way: if we do not have a
marketing campaign (A),
then sales will decrease
(X) and expenses
increase (B), cash flow
will decrease (Y), and finally, the bond will default (Z). This is called forward chaining "start from
the known facts and move forward by applying inference rules to extract more data, and it
continues until it reaches to the goal." We can start from the goal (Z)and do backward chaining
"starts from the goal, move backward by using inference rules to determine the facts that satisfy the
goal."

1
0
References
http://www.aijbaf.com/PDF/AIJBAF-2020-04-09-03.pdf
https://www.investopedia.com/terms/f/five-c-credit.asp

https://ebs.online.hw.ac.uk/EBS/media/EBS/PDFs/Credit-Risk-Management.pdf
http://www.magnanimitas.cz/ADALTA/0101/papers/jasinski.pdf
https://www.youtube.com/watch?v=G7CVLKPlBZo&t=2926s&ab_channel=AnalystPrep

1
1