TUT4

1. Define credit risk.

- Credit risk is the risk that the principal and interest payable on a loan will not be paid in a
timely manner. For most loans, documentation generally defines this as on or before the
due date.
2. What are expert systems? Outline the problems with relying on expert systems
- Expert systems are procedures for analysing loan proposals that are largely based on the
skill of the credit analyst. They are normally applied using acronyms such as the 5 C’s or
PARSER. A characteristic of expert systems is that financial analysis takes up little
part of the overall analysis. In other words, the much of the analysis tends to be
subjective rather than objective. Ratio analysis tends to be the only objective analysis for
this procedure. It is the subjectivity that causes the most problem for expert systems.
Both the analysis of the framework and the data can be ambiguous. In addition to this,
there is no doubt that the more complex the loan, the less appropriate
3. What is the basis of using market-based risk premiums? Why do credit analysts not use
them more regularly?
- The basis of market-based premiums is that the probability of repayment or default risk
of a loan can be determined from the term structure of credit risk. This is a similar
concept to the term structure of interest rates. Simply put, it is the probability of
repayment that makes a lender indifferent between risky corporate debt and risk free
government debt. The problem with the approach is that it assumes that the premium
between risk free and risky debt is all credit risk. However, research has been shown that
the premium is not all credit risks and represents other factors as well. These factors
include:
+ The liquidity of the debt issue.
+ Any covenants on the debt issue.
+ The seniority of the debt issue
+ Industry issues
4. How has the development of statistical tools help credit analysts? Explain why these
tools cannot be the sole basis for decision-making.
- Prior to the development of statistical tools for credit analysis, loans were made using
expert systems that used the expertise of the analyst as its basis. They were prone to error
due to the reliance of human judgement. The introduction of statistical tools has taken the
subjectivity out of credit analysis. Instead of human judgement being the basis of
assessment, statistical tools ensured that more objective measures were used. These
objective measures can then be measured against a benchmark. However, these tools
cannot be the sole basis for decision-making for the following reasons:
+ They tend not to have the value of the loan as part of the assessment
+ They do not model terms, conditions and covenants.
+ They do not have seniority as part of their models.
+ They ignore the relationship, (which could be a good thing).
+ No matter how comprehensive the model, they may omit at least one variable
that is important for credit risk management or measurement
5. Explain the basis of discriminant analysis for credit analysis and compare it with
hybrid systems of analysis.
- Discriminant analysis seeks to distinguish between two populations using a set
number of characteristics. In short it is a statistical method and does not necessarily
utilise any financial theory. However, it may assist in the analysis of creditworthy and
non-creditworthy companies. On the other hand, hybrid systems seek to utilise well-
recognised models in the explanation of credit risk.The remaining questions are based on
the following proposal.A financial services provider that provides computer software
systems approaches you. The company started off as a small private company and has
grown strongly over the past fifteen years and listed on the Australian Stock Exchange.
The company has businesses in many off-shore locations, all of which are well-developed
capital markets. In some parts of the world, the company has near-monopoly markets.As
part of its strategy, the company uses acquisitions rather than growth to continue to
expand the business. While the business is software based, it relies on continued activity
in the financial markets.The company has had the same management over the past
fifteen years and the senior management team are shareholders in the company.The
company is rated BBB and its bonds are trading at 3.3 per cent above the
comparable government bond rate, with the share price being $5.60. Your bank’s
experience is that the recovery rate in the event of default, the recovery rate is 50 per
cent.The condensed financial accounts are as follows: