Level 1 CFA® Exam:
Credit Risk & Credit-Related Risks
Credit risk is the risk of incurring a loss as a result of the issuer not being able to make full and timely payments of interest and/or principal.
There are 2 components of credit risk:
- default probability (aka. default risk),
- loss severity (aka. loss given default).
Default probability is the probability that the issuer will default or in other words won’t be able to repay the scheduled amounts. The higher the default risk, the greater the probability that investors will lose some or all of the money invested.
Loss severity is how large the loss of investors (in %) will be in case of default. Loss severity is equal to \(1-\text{recovery rate}\).
The expected loss depends on default probability and loss severity:
Data about default risk and loss severity for 2 corporate bonds traded in the market is given below:
Bond A:
default probability = 10%
loss severity = 33%
Bond B:
default probability = 20%
loss severity = 50%
Compute the expected loss for both bonds.
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Remember: Usually different bond classes holders are subject to different amounts of credit risk.
The yield-to-maturity of an option-free corporate bond can be presented as the sum of a government benchmark yield and a spread over the benchmark.
The size of the spread (given in basis points) depends on the spread risk.
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- Credit risk is the risk of incurring a loss as a result of the issuer not being able to make full and timely payments of interest and/or principal.
- There are 2 components of credit risk: default probability (aka. default risk) and loss severity (aka. loss given default).
- The yield-to-maturity of an option-free corporate bond can be presented as the sum of a government benchmark yield and a spread over the benchmark.
- Spread risk consists of 2 risks: credit migration risk and market liquidity risk.