Temp_store

LO 33.2: Explain the differences between retail credit risk and corporate credit risk.
There are several features that distinguish retail credit risk from corporate credit risk. As mentioned earlier, retail credit exposures are relatively small as components of larger portfolios such that a default by any one customer will not present a serious threat to a lending institution. A commercial credit portfolio often consists of large exposures to corporations that can have a significant impact on their industry and the economy overall.
Due to the inherent diversification of a retail credit portfolio and its behavior in normal markets, estimating the default percentage allows a bank to effectively treat this loss as a cost of doing business and to factor it into the prices it charges its customers. A commercial credit portfolio is subjected to the risk that its losses may exceed the expected threshold, which could have a crippling effect on the bank.
Banks will often have time to take preemptive actions to reduce retail credit risk as a result of changes in customer behavior signaling a potential rise in defaults. These preemptive actions may include marketing to lower risk customers and increasing interest rates for higher risk customers. Commercial credit portfolios typically dont offer these signals, as problems might not become known until it is too late to correct them.
T h e D a r k S i d e o f R e t a i l C r e d i t R i s k

LO 33.1: Analyze the credit risks and other risks generated by retail banking.
The retail banking industry revolves around receiving deposits from and lending money to consumers and small businesses. Loans can take the form of home mortgages, home equity lines of credit (HELOCs), installment loans (revolving loans covering automobiles, credit cards, etc.), and small business loans (SBLs). From the perspective of the lending institution, these individual loans constitute small pieces of large portfolios designed to reduce the incremental risk to any one exposure.
The biggest risk associated with retail banking is credit risk, which is the likelihood that a borrower will default on debt. Throughout the five years preceding the 2007 subprime mortgage crisis, banks offered customers products they could not afford with risks that were more than customers could bear. Loan-to-value (LTV) ratios on mortgaged properties were very high and borrowers with weaker credit were given mortgages. These strategies backfired when housing prices collapsed, which resulted in mortgages often exceeding the value of the properties themselves.
Although credit risk is the primary risk in retail banking, several other risks also impact the industry. These risks include:
Operational risks: day-to-day risks associated with running the business.
Business risks: strategic risks associated with new products or trends and volume risks associated with measures like mortgage volume when rates change.
Reputation risks: the banks reputation with customers and regulators.
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Interest rate risks: the bank provides specific interest rates to its assets and liabilities and rates change in the marketplace.
Asset valuation risk: a form of market risk associated with the valuation of assets,
liabilities, and collateral classes. An example includes prepayment risk associated with mortgages in decreasing rate environments. Valuation risk also exists in situations when car dealers assume a residual value for a vehicle at the end of the life of a lease.
R e t a i l C r e d i t R i s k v s . C o r p o r a t e C r e d i t R i s k

LO 32.8: Describe the common pitfalls in stress testing CCR.
Stress testing CCR includes the following pitfalls:

Stress testing CCR is a relatively new method, and institutions typically do not aggregate CCR with loan portfolio or trading position stress tests. Institutions typically stress test current exposure when incorporating the losses with loan or trading position. This is a mistake, because institutions should instead use expected exposure or positive expected exposure.
Using current exposure can lead to significant errors, which is particularly evident in
at-the-money exposures when measuring derivatives market values.
When calculating changes in exposures, using delta sensitivities is also challenging for
CCR since delta is nonlinear. The linearization of delta sensitivities in models can lead to significant errors.
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K e y C o n c e p t s
LO 32.1
The four definitions of counterparty credit risk (CCR) exposure measures are:
Current exposure, or replacement cost, is the greater of zero or the market value of a

transaction (or transactions) upon counterparty default, assuming no recovery in value. Peak exposure measures the distribution of exposures at a high percentile (93% or 99%) at a given future date before the maturity of the longest maturity exposure in the netting group. Expected exposure measures the mean distribution of exposures at a given future date prior to the maturity of the longest maturity exposure in the netting group. Expected positive exposure (EPE) is the weighted average of expected exposures over time, where the weights represent the proportion of individual expected exposures of the entire time interval.
LO 32.2
Credit valuation adjustment (CVA) represents the market value of the CCR. Financial institutions could view CCR as either credit risk or market risk, although it should consider both risks.
Treating CCR as credit risk exposes an institution to changes in CVA. CVA should, therefore, be included in valuing a derivatives portfolio, otherwise the portfolio could experience large changes in market value.
Treating CCR as market risk allows an institution to hedge market risk losses; however, it leaves the institution exposed to declines in counterparty creditworthiness and default.
Treating CCR as both credit risk and market risk is prudent, but this approach is complex and difficult to interpret.
LO 32.3
The most common stress test is stress testing current exposure. Stresses may include equity crash simulations, other credit events, or interest-rate shocks. Counterparties with the largest current exposures are generally reported to senior management.
Stress tests of current exposure have two primary shortcomings. First, aggregating results is challenging and stresses do not factor in the credit quality of the counterparty. Second, they do not provide information on wrong-way risk.
LO 32.4
In a loan portfolio, the expected loss (EL) for any one counterparty is a function of the probability of default (PD^, exposure at default (EATX), and loss given default (LGDj). The EL for a portfolio is the sum of the individual exposures.
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The stressed expected loss (ELS) is determined by stressing the PD. The stress loss for the loan portfolio is, therefore, the difference between the stressed EL and EL.
In a derivatives portfolio, the EL for any counterparty is a function of PDj, LGDp and expected positive exposure (EPE^ multiplied by an alpha factor (a).
LO 32.3
Currently, institutions typically only consider a counterpartys probability of default (PD) to the institution (i.e., unilateral CVA). A financial institution should instead consider its bilateral CVA, or the possibility that counterparties could default to the institution and the possibility that the institution could default to its counterparties.
LO 32.6
The formula for calculating CVA across all counterparties is a function of the discounted expected exposure, the risk-neutral marginal probability for a counterparty, and the risk- neutral LGD. The formula depends on market variables, including credit spreads, market spreads, and derivatives values. To calculate a stressed CVA (CVAS), an instantaneous shock is applied to these market variables. The stress loss is the difference between CVAS and CVA.
LO 32.7
Financial institutions should incorporate the value of their option to default to a counterparty through the bilateral CVA, also known as the debt value adjustment (DVA).
The BCVA formula differs from the CVA formula in that BCVA incorporates negative expected exposure (NEE) and the probability of the counterpartys survival.
The probability of survival depends on credit default swap spreads, and the losses depend on the institutions own credit spread. The financial institution should consider stress results for the BCVA. Stress losses are calculated by subtracting the value of the current BCVA from the stressed BCVA.
LO 32.8
Shortcomings of stress testing CCR include:
CCR is not aggregated with loan portfolio or trading position stress tests.
Stress testing current exposure is not optimal. Instead, institutions should use expected exposure or positive expected exposure.
Using current exposure can lead to significant errors, especially for at-the-money
exposures, when measuring derivatives market values.
The linearization of delta sensitivities in models can lead to significant errors.
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C o n c e p t C h e c k e r s
1.
2.
3.
4.
3.
Which of the following exposure measures reflects the average distribution of exposures at a specific future date prior to the maturity of the longest maturity transaction within a netting set? A. Peak exposure. B. Current exposure. C. Expected exposure. D. Expected positive exposure.
Is the following statement on the treatment of counterparty credit risk (CCR) correct? Treating CCR as a market risk does not allow an institution to hedge market risk losses, and it exposes the institution to declines in counterparty creditworthiness and default. A. The statement is correct with regard to both hedging market risk losses and
counterparty creditworthiness and default.
B. The statement is incorrect with regard to both hedging market risk losses and
counterparty creditworthiness and default.
C. The statement is correct with regard to hedging market risk losses only. D. The statement is correct with regard to counterparty creditworthiness and
default only.
An analyst notes that stress testing current exposure is problematic because aggregating results is typically not meaningful, although it is easy to account for the credit quality of the counterparty. Are the analysts statements correct? A. The analyst is correct with regard to both aggregating results and credit quality. B. The analyst is correct with regard to aggregating results only. C. The analyst is correct with regard to credit quality only. D. The analyst is incorrect with regard to both aggregating results and credit
quality.
Which of the following statements best reflects the reason why a financial institution does not need to consider aggregating stresses to the expected positive exposure (EPE) with its loan portfolio? A. Loans are not sensitive to market variables. B. Stresses to EPE are not sensitive to market variables. C. The EPE and the loan portfolio are negatively correlated. D. The EPE and the loan portfolio are positively correlated.
Is the following statement on bilateral credit valuation adjustment (BCVA) correct? The formula for BCVA is similar to the formula for CVA, except that the BCVA formula uses expected positive exposure (EPE) and it incorporates the probability of the counterpartys survival. A. The statement is correct with regard to both EPE and probability of survival. B. The statement is correct with regard to EPE only. C. The statement is correct with regard to probability of survival only. D. The statement is incorrect with regard to both EPE and probability of survival.
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C o n c e p t C h e c k e r A n s w e r s
1. C Expected exposure measures the mean distribution of exposures at a given future date prior
to the maturity of the longest maturity exposure in the netting group.
2. D Treating CCR as a market risk allows an institution to hedge market risk losses; however, it leaves the institution exposed to declines in counterparty creditworthiness and default. CCR can be hedged by the ongoing replacement of contracts with a counterparty instead of waiting for default to occur.
3. B The analyst is correct to state that aggregating stress results is not meaningful. Simply taking
the sum of all exposures only considers the loss that would occur if all counterparties were to simultaneously default. This is an unlikely scenario. The analyst s statement on credit quality of the counterparty is incorrect since stresses do not factor in the credit quality of the counterparty.
4. A A financial institution does not need to consider aggregating stresses to the EPE with its loan portfolio, because loans are not sensitive to market variables and, therefore, will not have any exposure changes from changes in market variables.
5. C The BCVA formula differs from the CVA formula in that BCVA incorporates negative
expected exposure (NEE), and the probability of the counterpartys survival must be included in the BCVA formula.
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The following is a review of the Credit Risk Measurement and Management principles designed to address the learning objectives set forth by GARP. This topic is also covered in:
C r e d i t S c o r in g a n d R e t a il C r e d i t R i s k M a n a g e m e n t
Topic 33
E x a m F o c u s
This topic examines credit risk management, primarily from the perspective of the retail credit lender. For the exam, focus on the risks incurred by a lender and how credit scoring models can be used to incorporate variables into an effective risk evaluation model. While estimating risk and evaluating model performance is critical, assessing credit applicants for potential profitability is also important. Be familiar with the role of a credit applicant as both a borrower and a potential client for other lender products. Also, understand the concept of risk-based pricing and how it has changed the way that lenders price their products to different customers.
R e t a i l B a n k i n g R i s k s

LO 32.7: Calculate the DYA and explain how stressing DVA enters into aggregating stress tests o f CCR.
Financial institutions should include the liability effects in their stress calculations to properly calculate the CVA profit and loss. As a result, institutions could adequately incorporate the value of their option to default to a counterparty through the bilateral CVA. This component is often called the debt value adjustment (DVA).
The BCVA formula is similar to the CVA formula with two differences. First, BCVA incorporates negative expected exposure (NEE), which is calculated from the counterpartys perspective. Second, the option that the financial institution can default on its counterparty is dependent on the counterparty surviving first; therefore, the probability of the counterpartys survival must be included in the BCVA formula (we denote this as Sp with /representing the financial institution). This change must also be reflected in the CVA formula. The BCVA formula can therefore be set up as:
b c v a = +y l g d * x y e e ; (tj) x p d ; (tH . tj) x s; (t H)
N
T – y l g d ; x y n e e ; (tj) x p d ; (t h , tj) x s; (t H) N T N n=l T j= l
n1
j= l
The probability of survival depends on credit default swap (CDS) spreads, and the losses depend on the financial institutions own credit spread. Institutions should be aware that this may result in counterintuitive results, for example, implying that losses occur because the institutions credit quality has improved. In any case, the financial institution should consider stress results for the BCVA and calculate stress losses by subtracting the current BCVA from the stressed BCVA.
The benefit of incorporating BCVA is that it allows CCR to be treated as market risk, which enables CCR to be included in market risk stress testing consistently. Any gains or losses from the BCVA stress could then be added to the institutions stress tests from market risk.
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S h o r t c o m i n g s o f S t r e s s T e s t i n g CCR

LO 32.6: Calculate the stressed CVA and the stress loss on CVA.
Stress testing CCR for market risk events looks at the losses in market value of a counterparty exposure due to market risk events or credit spread changes. Financial institutions typically only consider the unilateral CVA for stress testing, which looks at a counterpartys default to the institution under various market events. However, financial institutions should also consider the possibility that they could default to their counterparties, and, as a result, should consider their bilateral CVA (BCVA), which is discussed in LO 32.7.
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To calculate the stressed CVA and the stress loss, lets first look at the formula for calculating CVA. The following is a simplified formula for CVA that does not factor in wrong-way risk:
CVAn = LGD*n x EE* (tj) X p d ; (th , tj)
T
H
where:
LGDn = risk-neutral loss given default EE* (tj) = risk-neutral discounted expected exposure PDn(tj_l5tj) = risk-neutral marginal default probability
When aggregating across iV counterparties in a portfolio, the formula for CVA becomes:
N
T
CVA = ^ 2 LGD* x ^ EE* (tj) x PD* (tj_,, tj)
n=l
j=l
The components of this formula all depend on market variables, including credit spreads, market spreads, and derivatives values. Calculating a stressed CVA involves applying an instantaneous shock to these market variables, which could affect the discounted expected exposure or the risk-neutral marginal default probability. The stressed CVA can then be calculated as:
N
T
CVAS = J 2 LGD*n x y ; EEsn (t,) x PDsn (tH , t,)
11=1
j=l
The stress loss is simply the difference between CVAS and CVA.
Stress testing CCR in a credit-risk framework has similarities with stress testing in a market- risk framework. Both rely on EL as a function of LGD, exposure, and PD. Nevertheless, their values will differ depending on whether the view is from a market-risk or credit-risk perspective. The two primary differences include the use of risk-neutral values for CVA (versus physical values for ELs), and the use of ELs over the transactions life for CVA (versus a specific time horizon for ELs).
In addition, CVA uses a market-based model for calculating the PD. The market-based approach has the advantage of being able to incorporate a correlation between the exposure and the PD. This correlation can significantly influence the CVA. Because there is uncertainty regarding the correlation, financial institutions should run stress tests to determine the effects on profit and loss from incorrect correlation assumptions.
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S t r e s s T e s t i n g D e b t V a jl u e A d j u s t m e n t

LO 32.5: Describe a stress test that can be performed on CVA.

LO 32.4: Calculate the stressed expected loss, the stress loss for the loan portfolio and the stress loss on a derivative portfolio.
Loan Portfolios
The expected loss (EL) for any counterparty in a loan portfolio is a function of the probability of default (PD^, exposure at default (EAEL), and loss given default (LGDj). The EL for a portfolio is the sum of the individual exposures:
EL =
N
i=l
2PD; x EADj x LGD; J
Stress testing the EL could involve stressing the PD, which is a function of several other variables, including the unemployment rate or a relevant exchange rate. The stressed expected loss (ELS) is, therefore, conditional on the impact of these variables on the PD. The ELS can be expressed as:
ELS =
N
i=l
x EAD; x LGD;
The stress loss for the loan portfolio is the difference between ELS and EL. The financial institution could create different stress scenarios by increasing the PDs or by stressing the various variables. Note that the variables tend to be macroeconomic or balance sheet values.
Derivatives Portfolios
The EL and ELS for a derivatives portfolio are derived similarly to the loan portfolio in that they both use the PD and LGD. However, exposure at default, which is stochastic and depends on market factors, is replaced with the expected positive exposure (EPE^ multiplied by an alpha factor (a). This allows CCR exposures to be used in a portfolio credit model. We can then measure EL and ELS for derivatives portfolios as:
PDi x (EPEi x a ) x LGD{
EL =
N
i=l
N
ELS = ^ pD? x(EPEf x a jx L G D i
i=l
Stress losses are done on a portfolio of derivatives counterparties. Similar to the loan portfolio, the financial institution could create different stress scenarios by increasing the PDs, or by stressing macroeconomic variables, balance sheet values, or values of financial instruments.
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In the context of EPE, institutions could also stress market variables including swap rates and equity prices. The stresses to these variables may either increase or decrease EL. Their overall impact will depend in part on the directional bias of the financial institutions portfolio, which counterparties are margined, and which have excess margin. This differs from stresses on the loan portfolio, which tend to be directionally the same and, therefore, have similar effects across counterparties. It is important to note that an institution that conducts EPE stresses does not need to separately consider aggregating them with its loan portfolio, since loans are not sensitive to market variables and will not change exposures due to changes in these variables.
Financial institutions typically shock a series of market variables instantaneously. During these instantaneous shocks, the institution shocks the initial value of a derivative prior to running the EPE simulation. How much this affects EPE will depend in part on the degree of collateralization and the portfolios moneyness. A series of shocks could also be performed over time; however, the common approach is to perform shocks to current exposure only.
Financial institutions could also consider joint stresses between credit quality and market variables. Although this is conceptually easy, it is challenging in practice since the variables are not tied by any meaningful connection. Equity-based approaches may be the closest to modeling joint stresses; however, the link between a shock to exposure and the equity-based default probability is unclear. It is also difficult to model the connection between exposure and PD in calculating wrong-way risk. Currently, the best way to identify wrong-way risk is to stress current exposure and identify the counterparties most exposed to wrong-way risk.
Treating CCR as a credit risk allows an institution to improve the management of its loan portfolio. Performing stress tests to CCR allows aggregating losses with loan portfolios and allows considering counterparty credit quality. On the other hand, treating CCR as a market risk allows for easier joint stresses of credit quality and exposure, and allows an institution to derive the PD from market variables.
S t r e s s T e s t i n g C r e d i t V a l u a t i o n A d j u s t m e n t

LO 32.3: Describe a stress test that can be performed on a loan portfolio and on a derivative portfolio.
Stress testing current exposure is the most common stress test. Financial institutions apply current exposure stresses to each counterparty by repricing portfolios under a scenario of risk-factor changes. Counterparties with the largest current exposures and largest stressed current exposures are typically reported to senior management.
For example, an institution that is stress testing current exposure using an equity crash involving a 23% decline in equity markets may create a table of the top counterparties with the largest stressed current exposure and include their credit ratings, mark-to- market values, collateral values, and current exposures. In effect, the table would indicate to management which counterparties are most vulnerable to a large scale equity market decline and how much the counterparties would owe the financial institution. O f course, financial institutions could construct tables for other stresses as well, including credit events and interest-rate shocks. The different stress scenarios would likely include different counterparties.
However, stress tests of current exposure suffer from two main shortcomings: (1) aggregating results is challenging and (2) it does not provide information on wrong-way risk.
Aggregating stress results needs to incorporate additional information for it to be meaningful. Simply taking the sum of all exposures only looks at a loss that would occur if all counterparties were to simultaneously default, which is an unlikely scenario. In addition, the stressed current exposures do not factor in the credit quality of the counterparty. The stress results, therefore, only look at the trade values and not the counterpartys capacity or willingness to repay its obligations. This difference becomes especially relevant when comparing the exposures between high-risk early stage companies and highly rated mature companies. Nevertheless, the task of incorporating counterparty credit quality into each stress scenario is onerous.
The stress results of current exposure also do not provide information on wrong-way risk. Since the stress measures already omit the credit quality of the counterparty, they cannot provide meaningful information on the correlation of exposure with credit quality.
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S t r e s s T e s t i n g E x p e c t e d L o s s

LO 32.2: Explain the treatment o f counterparty credit risk (CCR) both as a credit risk and as a market risk and describe its implications for trading activities and risk management for a financial institution.
The treatment of CCR as a market risk was historically done through pricing in a credit valuation adjustment (CVA). CVA represents the market value of the CCR. Before the 20072009 financial crisis, institutions saw stable credit spreads and CVAs that made up only a small component of a derivatives portfolio. When the financial crisis resulted in unusual losses and gains, institutions began to pay closer attention to risk managing the CVA.
Financial institutions may view CCR as either a credit risk or a market risk and may manage the credit portfolio accordingly, but looking at it as only one type of risk (in a silo) exposes the institution to the risk from the other side.
Treating CCR as a credit risk exposes the institution to changes in CVA; therefore, CVA must be included when valuing a derivatives portfolio. Not including the CVA could lead to large swings in market value. Credit risk is managed at inception or typically through collateral arrangements, but it is not actively managed once the trades are set up. Since at default all trades need to be replaced in the market, emphasis is on risk mitigation and credit evaluation.
Treating CCR as a market risk allows an institution to hedge market risk losses but leaves it exposed to declines in counterparty creditworthiness and default. However, CCR can be hedged through replacing contracts with a counterparty instead of waiting for default to occur. This can be achieved by buying positions in proportion to the counterpartys probability of default (PD). A counterparty with a low PD will only have a small component of its trades replaced this way, while counterparties with deteriorating credit quality will see their trades replaced faster and moved to other counterparties.
The treatment of CCR as both a credit risk and a market risk creates a large variety of measurements that can be complex to interpret. For example, credit risk uses current exposure, peak exposure, and expected exposure, while market risk uses CVA and variability in CVA (measured by VaR of CVA). When stress testing the portfolio, the number of stress
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results can be very large. By classifying CCR as both a credit risk and a market risk, the number of stress results would equal at least twice the number of counterparties plus one (stresses are run for each counterparty as well as the aggregate portfolio), and would be at least double that amount again if instantaneous shocks were considered in addition to stressed risk measures.
S t r e s s T e s t i n g C u r r e n t E x p o s u r e

LO 32.1: Differentiate am ong current exposure, peak exposure, expected exposure, and expected positive exposure.
The concept of counterparty credit risk (CCR) and its measurement and management gained prominence in the 1990s, and it now forms a critical part of most organizations risk governance. Financial institutions incorporated CCR through analyzing their derivatives exposures and by tracking the current exposure to their counterparties. Institutions measured regulatory capital for CCR as add-ons to current exposures, calculated as a percentage of gross notional derivatives values.
With the rise in importance of measuring CCR, modeling CCR also evolved. Initially, potential exposure models were used to measure and limit CCR. This approach evolved into expected positive exposure models, which allowed derivatives to be incorporated into portfolio risk models along with loans. The measurement of CCR also formed the basis for regulatory capital under Basel II and allowed for the incorporation of credit mitigants into risk modeling, including netting agreements.
There are four important definitions of exposure measures:
Current exposure. Also called replacement cost, current exposure is the greater of (1) zero or (2) the market value of a transaction (or a portfolio of transactions) that would be lost if the counterparty defaulted and no value was recovered during bankruptcy. Peak exposure. Peak exposure measures the distribution of exposures at a high percentile (93% or 99%) at a given future date prior to the maturity of the longest maturity exposure in the netting group. Peak exposure is usually generated for many future dates.

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Expected exposure. Expected exposure measures the mean (average) distribution of exposures at a given future date prior to the maturity of the longest maturity exposure in the netting group. Expected exposure is also typically generated for many future dates. Expected positive exposure (EPE). EPE is the weighted average of expected exposures over time. The weights represent the proportion of individual expected exposures of the entire time interval. For the purposes of calculating the minimum capital requirement, the average is measured over the first year or over the length of the longest maturing contract.
One of the issues with CCR is wrong-way risk. Wrong-way risk is the risk that the exposure from a counterparty grows at the same time that the risk of default by the counterparty increases. Note that wrong-way risk does not arise with fixed-rate loans.
C C R T r e a t m e n t