Estimated reading time: 9 minutes

## Introduction

We present part 6 of the learning outcomes, as prescribed by GARP.

## Credit Risk Measurement and Management

This area focuses on a candidate’s understanding of credit risk management, with some focus given to structured finance and credit products such as collateralized debt obligations and credit derivatives.

The broad areas of knowledge covered in readings related to Credit Risk Measurement and Management include the following:

Credit analysis

Default risk: quantitative methodologies

Expected and unexpected loss

Credit VaR

Counterparty risk

Credit derivatives

Structured finance and securitization

## The Credit Decision

Define credit risk and explain how it arises using examples.

Explain the components of credit risk evaluation.

Describe, compare, and contrast various credit risk mitigants and their role in credit analysis.

Compare and contrast quantitative and qualitative techniques of credit risk evaluation.

Compare the credit analysis of consumers, corporations, financial institutions, and sovereigns.

Describe quantitative measurements and factors of credit risk, including probability of default, loss given default, exposure at default, expected loss, and time horizon.

Compare bank failure and bank insolvency.

## The Credit Analyst

Describe the quantitative, qualitative, and research skills a banking credit analyst is expected to have.

Assess the quality of various sources of information used by a credit analyst.

Explain the capital adequacy, asset quality, management, earnings, and liquidity (CAMEL) system used for evaluating the financial condition of a bank.

## Capital Structure in Banks

Evaluate a bank’s economic capital relative to its level of credit risk.

Identify and describe important factors used to calculate economic capital for credit risk: probability of default, exposure, and loss rate.

Define and calculate expected loss (EL).

Define and calculate unexpected loss (UL).

Estimate the variance of default probability assuming a binomial distribution.

Calculate UL for a portfolio and the UL contribution of each asset.

Describe how economic capital is derived.

Explain how the credit loss distribution is modeled.

Describe challenges to quantifying credit risk.

## Rating Assignment Methodologies

Explain the key features of a good rating system.

Describe the experts-based approaches, statistical-based models, and numerical approaches to predicting default.

Describe a rating migration matrix and calculate the probability of default, cumulative probability of default, marginal probability of default, and annualized default rate.

Describe rating agencies’ assignment methodologies for issue and issuer ratings.

Describe the relationship between borrower rating and probability of default.

Compare agencies’ ratings to internal experts-based rating systems.

Distinguish between the structural approaches and the reduced-form approaches to predicting default.

Apply the Merton model to calculate default probability and the distance to default and describe the limitations of using the Merton model.

Describe linear discriminant analysis (LDA), define the Z-score and its usage, and apply LDA to classify a sample of firms by credit quality.

Describe the application of a logistic regression model to estimate default probability.

Define and Interpret cluster analysis and principal component analysis.

Describe the use of a cash flow simulation model in assigning ratings and default probabilities and explain the limitations of the model.

Describe the application of heuristic approaches, numeric approaches, and artificial neural networks in modeling default risk and define their strengths and weaknesses.

Describe the role and management of qualitative information in assessing probability of default.

## Credit Risks and Credit Derivatives

Using the Merton model, calculate the value of a firm’s debt and equity and the volatility of firm value.

Explain the relationship between credit spreads, time to maturity, and interest rates and calculate credit spread.

Explain the differences between valuing senior and subordinated debt using a contingent claim approach.

Explain, from a contingent claim perspective, the impact of stochastic interest rates on the valuation of risky bonds, equity, and the risk of default.

Compare and contrast different approaches to credit risk modeling, such as those related to the Merton model, CreditRisk+, CreditMetrics, and the KMV model.

Assess the credit risks of derivatives.

Describe a credit derivative, credit default swap, and total return swap.

Explain how to account for credit risk exposure in valuing a swap.

## Spread Risk and Default Intensity Models

Compare the different ways of representing credit spreads.

Compute one credit spread given others when possible.

Define and compute the Spread ‘01.

Explain how default risk for a single company can be modeled as a Bernoulli trial.

Explain the relationship between exponential and Poisson distributions.

Define the hazard rate and use it to define probability functions for default time and conditional default probabilities.

Calculate the unconditional default probability and the conditional default probability given the hazard rate.

Distinguish between cumulative and marginal default probabilities.

Calculate risk-neutral default rates from spreads.

Describe advantages of using the CDS market to estimate hazard rates.

Explain how a CDS spread can be used to derive a hazard rate curve.

Explain how the default distribution is affected by the sloping of the spread curve.

Define spread risk and its measurement using the mark-to-market and spread volatility.

## Portfolio Credit Risk

Define and calculate default correlation for credit portfolios.

Identify drawbacks in using the correlation-based credit portfolio framework.

Assess the impact of correlation on a credit portfolio and its Credit VaR.

Describe the use of a single factor model to measure portfolio credit risk, including the impact of correlation.

Define and calculate Credit VaR.

Describe how Credit VaR can be calculated using a simulation of joint defaults.

Assess the effect of granularity on Credit VaR.

## Structured Credit Risk

Describe common types of structured products.

Describe tranching and the distribution of credit losses in a securitization.

Describe a waterfall structure in a securitization.

Identify the key participants in the securitization process and describe conflicts of interest that can arise in the process.

Compute and evaluate one or two iterations of interim cashflows in a three-tiered securitization structure.

Describe a simulation approach to calculating credit losses for different tranches in a securitization.

Explain how the default probabilities and default correlations affect the credit risk in a securitization.

Explain how default sensitivities for tranches are measured.

Describe risk factors that impact structured products.

Define implied correlation and describe how it can be measured.

Identify the motivations for using structured credit products.

## Counterparty Risk and Beyond

Describe counterparty risk and differentiate it from lending risk.

Describe transactions that carry counterparty risk and explain how counterparty risk can arise in each transaction.

Identify and describe institutions that take on significant counterparty risk.

Describe credit exposure, credit migration, recovery, mark-to-market, replacement cost, default probability, loss given default, and the recovery rate.

Describe credit value adjustment (CVA) and compare the use of CVA and credit limits in evaluating and mitigating counterparty risk.

Identify and describe the different ways institutions can quantify, manage, and mitigate counterparty risk.

Identify and explain the costs of an OTC derivative.

Explain the components of the X-Value Adjustment (xVA) term.

## Netting, Close-out and Related Aspects

Explain the purpose of an ISDA master agreement.

Summarize netting and close-out procedures (including multilateral netting), explain their advantages and disadvantages, and describe how they fit into the framework of the ISDA master agreement.

Describe the effectiveness of netting in reducing credit exposure under various scenarios.

Describe the mechanics of termination provisions and trade compressions and explain their advantages and disadvantages.

Identify and describe termination events and discuss their potential effects on parties to a transaction.

## Margin (Collateral) and Settlement

Describe the rationale for collateral management.

Describe the role of a valuation agent.

Describe the mechanics of collateral and the types of collateral that are typically used.

Explain the process for the reconciliation of collateral disputes.

Explain the features of a collateralization agreement.

Differentiate between a two-way and one-way CSA agreement and describe how collateral parameters can be linked to credit quality.

Explain aspects of collateral including funding, rehypothecation, and segregation.

Explain how market risk, operational risk, and liquidity risk (including funding liquidity risk) can arise through collateralization.

Describe the various regulatory capital requirements.

## Future Value and Exposure

Describe and calculate the following metrics for credit exposure: expected mark-to-market, expected exposure, potential future exposure, expected positive exposure and negative exposure, effective expected positive exposure, and maximum exposure.

Compare the characterization of credit exposure to VaR methods and describe additional considerations used in the determination of credit exposure.

Identify factors that affect the calculation of the credit exposure profile and summarize the impact of collateral on exposure.

Identify typical credit exposure profiles for various derivative contracts and combination profiles.

Explain how payment frequencies and exercise dates affect the exposure profile of various securities.

Explain the impact of netting on exposure, the benefit of correlation, and calculate the netting factor.

Describe the differences between funding exposure and credit exposure.

Explain the impact of collateralization on exposure and assess the risk associated with the remargining period, threshold, and minimum transfer amount.

Assess the impact of collateral on counterparty risk and funding, with and without segregation or rehypothecation.

## CVA

Explain the motivation for and the challenges of pricing counterparty risk.

Describe credit value adjustment (CVA).

Calculate CVA and CVA as a spread with no wrong-way risk, netting, or collateralization.

Evaluate the impact of changes in the credit spread and recovery rate assumptions on CVA.

Explain how netting can be incorporated into the CVA calculation.

Define and calculate incremental CVA and marginal CVA and explain how to convert CVA into a running spread.

Explain the impact of incorporating collateralization into the CVA calculation, including the impact of margin period of risk, thresholds, and initial margins.

Describe debt value adjustment (DVA) and bilateral CVA (BCVA).

Calculate DVA, BCVA, and BCVA as a spread.

Describe wrong-way risk and contrast it with right-way risk.

Identify examples of wrong-way risk and examples of right-way risk.

Discuss the impact of collateral on wrong-way risk.

Identify examples of wrong-way collateral.

Discuss the impact of wrong-way risk on central counterparties.

Describe the various wrong-way modeling methods including hazard rate approaches, structural approaches, parametric approaches, and jump approaches.

Explain the implications of central clearing on wrong-way risk.

## The Evolution of Stress Testing Counterparty Exposures

Differentiate among current exposure, peak exposure, expected exposure, and expected positive exposure.

Explain the treatment of 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.

Describe a stress test that can be performed on a loan portfolio, and on a derivative portfolio.

Calculate the stressed expected loss, the stress loss for the loan portfolio, and the stress loss on a derivative portfolio.

Describe a stress test that can be performed on CVA.

Calculate the stressed CVA and the stress loss on CVA.

Calculate the DVA and explain how stressing DVA enters into aggregating stress tests of CCR.

Describe the common pitfalls in stress testing CCR.

## Credit Scoring and Retail Credit Risk Management

Analyze the credit risks and other risks generated by retail banking.

Explain the differences between retail credit risk and corporate credit risk.

Discuss the “dark side” of retail credit risk and the measures that attempt to address the problem.

Define and describe credit risk scoring model types, key variables, and applications.

Discuss the key variables in a mortgage credit assessment and describe the use of cutoff scores, default rates, and loss rates in a credit scoring model.

Discuss the measurement and monitoring of a scorecard performance including the use of cumulative accuracy profile (CAP) and the accuracy ratio (AR) techniques.

Describe the customer relationship cycle and discuss the trade-off between creditworthiness and profitability.

Discuss the benefits of risk-based pricing of financial services.

## The Credit Transfer Markets — and Their Implications

Discuss the flaws in the securitization of subprime mortgages prior to the financial crisis of 2007.

Identify and explain the different techniques used to mitigate credit risk and describe how some of these techniques are changing the bank credit function.

Describe the originate-to-distribute model of credit risk transfer and discuss the two ways of managing a bank credit portfolio.

Describe covered bonds, funding CLOs, and other securitization instruments for funding purposes.

Describe the different types and structures of credit derivatives including credit default swaps (CDS), first-to-default puts, total return swaps (TRS), asset-backed credit-linked notes (CLN), and their applications.

## An Introduction to Securitisation

Define securitization, describe the securitization process, and explain the role of participants in the process.

Explain the terms over-collateralization, first-loss piece, equity piece, and cash waterfall within the securitization process.

Analyze the differences in the mechanics of issuing securitized products using a trust versus a special purpose vehicle (SPV) and Distinguish between the three main SPV structures: amortizing, revolving, and master trust.

Explain the reasons for and the benefits of undertaking securitization.

Describe and assess the various types of credit enhancements.

Explain the various performance analysis tools for securitized structures and Identify the asset classes they are most applicable to.

Define and calculate the delinquency ratio, default ratio, monthly payment rate (MPR), debt service coverage ratio (DSCR), the weighted average coupon (WAC), the weighted average maturity (WAM), and the weighted average life (WAL) for relevant securitized structures.

Explain the prepayment forecasting methodologies and calculate the constant prepayment rate (CPR) and the Public Securities Association (PSA) rate.

## In closing

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