1. Credit Risk
a. describe credit risk and credit-related risks affecting corporate bonds;
b. describe default probability and loss severity as components of credit risk;
What is credit risk?
Credit risk is the risk of loss of interest and/or principal stemming from a borrower's failure to repay a loan.
What are the two components of credit risk?
- Default probability
- Loss severity (Loss Given Default (LGD))
What is the formula for Expected Loss?
Expected Loss = Default probability X Loss severity
What is a credit spread?
The part of the loan risk premium representing the default risk is known as the credit spread.
What two factors could credit risk be on account of?
- Downgrade risk - the risk that the issuer will be downgraded, resulting in an increase in the credit spread demanded by the market
- Market liquidity risk - the widening of the bid-ask spread on an issuer's bonds.