Credit Risk Models

Credit risk is an investor's risk of loss arising from a borrower who does not make payments as promised. Such an event is called a default.

Types of credit risk:

· Default risk

· Credit spread risk

· Downgrade risk

Credit risk includes Sovereign risk is the risk of a government becoming unwilling or unable to meet its loan obligations, or reneging on loans it guarantees. The existence of sovereign risk means that creditors should take a two-stage decision process when deciding to lend to a firm based in a foreign country. Firstly one should consider the sovereign risk quality of the country and then consider the firm's credit quality.

Five macroeconomic variables that affect the probability of sovereign debt rescheduling are: Debt service ratio; Import ratio; Investment ratio; Variance of export revenue; Domestic money supply growth

And Counterparty risk, (otherwise known as default risk), is the risk that an organization does not pay out on a bond, credit derivative, credit insurance contract, or other trade or transaction when it is supposed to. Even organizations who think that they have hedged their bets by buying credit insurance of some sort still face the risk that the insurer will be unable to pay, either due to temporary liquidity issues or longer term systemic issues.

 

The type of credit risk model used to estimate a rating and a probability of default of a borrower is a central question. If the model used to establish the ratings is wrong then: (1) the pricing of the credit itself will be wrong, (2) the equity requirement won’t be optimal and (3) the risk itself won’t be correctly evaluated. Traditionally, two types of models are opposed: structural models and reduced forms models. The structural models are based on the firm value. The reduced forms models are ’intensity based models’.

The structural credit risk model, or asset value model is a model for assessing credit risk, typically of a corporation's debt (KMV model).

The model considers a corporation financed through a single debt and a single equity issue. The debt comprises a zero-coupon bond that matures at time t = t*, at which time it is to pay investors b dollars. The equity pays no dividends.

Intensity based model

The model is designed for large portfolios of corporate bonds. It does not explain default table term structure of interest rate. It fits term structure of interest rate into market data. The defaults are exogenous.

B(t; T) = _B(t;Nt; rt; T); where Nt is the number of defaults in [0; T] in the portfolio. Nt will be modeled by the Non-homogeneous Poisson Process named Cox process.

96. International Diversification: investing in different markets.

International diversification is a process which involves expanding an investment portfolio across two or more countries. It became a popular practice in the 1990s, as advances in tech

nology allowed for better communication across borders, and continues to be a common investment strategy.

International diversification is partially based on internalization theory, which suggests that corporations reduce costs and improve functionality by "internalizing," or setting up plants in various countries so that the corporation can absorb more local responsibility (and avoid paying someone else to do it).

A chief benefit of international investment diversification is the ability to spread currency risk; while a market in one region or nation may collapse, it is unlikely that all markets will collapse. International diversification may also reduce company costs and allow for quicker innovation.

Despite its popularity, there are serious barriers to international diversification. This includes language problems, the threat of political upheaval damaging capital, uneven levels of government transparency and the inability to guarantee redress in the event that things go awry.

International diversification is a primarily long-term approach which may not yield many benefits in the short term. Because of this, it requires a time commitment; that time depends on the particular circumstances of each company.

Managed funds enable you to invest while allowing you to pass the burden of management and investment strategy into the hands of specialists. Even if you have never invested before, a managed fund can make it easy for most people to enter the investment market. You don't need a lot of expertise to become an investor, because you can leave the investment decisions to professionals.

By pooling your money with other investors, the fund manager has the buying power to invest in many different asset classes and sectors on your behalf to spread your investment. The professionals managing the fund locate investment opportunities and work to achieve better results than you might expect to achieve on your own.