Credit Default Risk
Also known as Default Risk, standard credit risk, static risk
This the risk that the company defaults on its promised payments (in the context of bonds this is coupons and principal)
If a company goes bankrupt it will not be able to make any future coupon payments or return the principal at maturity
In this situation the investor losses 100% of their investment.
The job rating agencies is to assess the likehood of default
loss depends on seniority and security
Technical debt - is when you break one of the covenants
Priority - taxman, employees, banks, senior secured debt, senior unsecured, junior, equity
Longer term securities will have higher default risk (more time for things to go wrong)
Bonds with higher default risk will have a higher yield (lower price)
Credit risk can arise in any situation where there is a contract between two counterparties giving one party a future obligation to the other.
The risk being that the first party will fail to meet its obligations.
This means you have to look beyond a total default situation.
Also default risk is very important, credit risk also encompasses any waiver, deferral, rescheduling or any adjustment of the terms that is unfavourable to the creditor.
This is actually divided into 2 different parts
Protection Buyers - may own the asset (not always) and are looking for cover
Protection Sellers - want exposure to the asset (will provide cover)
This is the amount a lender (investor) can potentially lose in the event that a borrower (issuer) defaults.
Some financial instruments (bonds and loans) have credit exposure arising because there is a possibility that a borrower may not fulful contractual obligations in terms of repaying interest or principal.
There is also credit exposure on derivative instruments as well (such as swaps)
At inception, the credit exposure for either of the parties to an interest rate swap is zero.
Companies always presents a more conservative outlook than that given to the Equity Analysts
The lower the credit rating the higher the risk of default.
Investors who buy government bonds (from developed countries) are virtually free from credit risk.
Derivative Credit Exposure
This credit exposure is always dynamic
Lets consider an interest rate swap which is an exchange of cash flows
At inception the present value of the fixed and floating flows should be equal, so in the event of a default there is no significant credit risk
However after inception the market variables change and the two flows are no longer equal.
If the vaue of the flows is positive to an agent, then in the event of a counterparty default the transaction will have to be replaced at a loss
If the value of the flows is negative to an agent then they would be indifferent to a default.
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