credit risk1
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Credit riskis an investor's risk of loss arising from
a borrower who does not make payments as
promised. Such an event is called a default.Another term for credit risk is default risk.
Credit risks are a vital component of
fixed-income investing.
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Investor losses include :
lost principal and interest,
decreased cash flow, andincreased collection costs,
which arise in a number of circumstances like :
1. A consumer does not make a paymentdue on a mortgage loan, credit card, line of
credit, or other loan.
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2. A business does not make a payment due on a
mortgage, credit card, line of credit, or other loan.
3. A business or consumer does not pay a trade
invoice when due.
4. A business does not pay an employee's
earned wages when due.
5. A business or government bond issuer does
not make a payment on a coupon or principal
payment when due.
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6. An insolvent insurance company does not pay a policy
obligation.
7. An insolvent bank won't return funds to a depositor.
8. A government grants bankruptcy protection
to an insolvent consumer or business.
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Thus, Credit riskis risk due to uncertainty in a
counterparty's (also called an obligor's or credit's)
ability to meet its obligations.
There are :
many types ofcounterpartiesfrom
individuals to sovereign governments,
many different types ofobligationsfrom
auto loans to derivatives transactions
Thus, credit risk takes many forms.
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In simple words, Credit Risk is defined as:
The risk that a borrower will be unable to make payment
of interest or principal in a timely manner.
Credit risk is the oldest risk among the various types of
risk in the financial system.
Growth in markets, disintermediation, and
the introduction of number of innovativeproducts & practices have changed the way
credit risk is measured & managed in todays
environment.
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Studies have carried out on bank failures in U.S show
that Credit Risk alone has accounted for 71% of large
bank failures in the period from 1980 to 2004.
Credit risk arises from many banking credit riskmanagement activities apart from traditional lending.
Credit riskcan be segmented into 2
major segments:
1. Intrinsic credit risk
2. Portfolio credit risk
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The focus ofintrinsic riskis the measurement of risk at
individual loan level. This is carried out at lending unit
level.
Portfolio riskarises as a result of concentration of portfolio
to a particular sector,
geographic area,
industry,type of facility,
type of borrowers,
similar rating, etc.
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Concentration riskis managed at bank level as it is more
relevant at that level.
Management of Credit Risk:
1. Cash Payment with order
2. Cash On Delivery
3. Open Account
4. Consignment Accounts
5. Bills of Exchange
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Increase in bankruptcies
Deregulation
Disintermediation Shrinking margins on loans
Growth of off-balance sheet risk
Volatility in the value of collateral
Advances in finance theory & computertechnology
Risk based capital regulations
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The effective credit risk management framework
comprises of distinctive building blocks:
a) Policy & strategyb) Organizational structure
c) Operations/systems.
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Approaches to credit risk measurement:
intrinsic risk
Expert Systems
Credit Ratings
Credit Scoring
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A credit risk model determines the present value of a given
loan or fixed income security, given our past experience and
assumptions about future.Credit risk models are intended to aid banks in quantifying,
aggregating & managing risk across geographical & product
lines.
It may result in better internal riskmanagement
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Creditrisk
models
Z-scoremodel
KMVmodel
CreditMetrices
Creditrisk+
model
4 models are available for measuring credit
risk:
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Principles of assessment of banks management of credit
risk:Establishing an appropriate credit risk
environmentOperating under a sound credit granting process
Maintaining an appropriate credit
administration, measurement & monitoring
process.Ensuring adequate controls over credit risk
The role f supervisors.
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There are many risks involved in exporting. They are:
Credit risk
Poor quality riskTransportation and logistics risks
Legal risks
Political risks
Unforeseen risksExchange rate risks
Cultural and language risks
Companies need to develop a professional approach when
entering the field of exporting.
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Companies will also face greater competition and more
stringent rules and regulations pertaining to products and
packaging.
Poor quality risk:
If the goods to be exported are not inspected
before they are shipped by an independent
third-party, the exporter may find his entireshipment being rejected on arrival at the
importer's premises due to the poor quality of
the goods.
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Credit risk in exporting:
In most instances - mainly because of the large
distances and alien environments involved - it is
generally difficult for the exporter to verify the
creditworthiness and reputation of an importer. If thecreditworthiness of a foreign buyer is unknown there is
the increased risk of non-payment,
late payment or even
straightforward fraud.
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It is essential, therefore, that the exporter should strive to
determine the creditworthiness of the foreign buyer.
Transportation and logistic risks:
With the movement of goods from one
continent to another, or even within the
same continent, goods face many hazards.
There is the risk of theft, damage and
possibly the goods not even arriving at all.
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Legal risks
International laws and regulations change frequently
and/or may be applied differently from that of theexporter's own country.
Political risk
The political stability of a foreign country
into which a company is exporting is of the
utmost importance.
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Unforseen risks
A natural disaster or terrorist action in a particular country
could completely destroy an export market for a company. Culture and language risk
Misunderstandings in communication and
in international trade transactions arisebecause in most instances the importer and
exporter come from different cultures and
express themselves with different languages.
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Exchange Rate risk:
The risk that a business' operations or an
investment's value will be affected by changesin exchange rates.
This risk usually affects
businesses, but it can also affect
individual investors who make
international investments. also
called currency risk.
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Managing Exporting Risks
The task of managing export-related risks begins with
knowing the kind of risk.
Steps in managing risk:
identify the risks
'weighting' the seriousness of the risk.
obtain insurance to cover the risk
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Three main types of risk cover include
credit risk cover,
country risk cover and transit risk cover
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