Credit risk function

In order to solve the probability of default, reduced-form models adopt a different approach. They are mainly based on debt prices rather than equity prices. In fact, they do not take into account the fundamentals of the firm and the default event is determined as an exogenous process without considering the underlying asset movements. In addition, the models are mainly based oti X t), that is the default intensity as a function of time. In particular, these models use the decomposition of the risky rate (risk-free rate and risk premium) in order to determine the default probabilities, recovery rates and debt values. Although structural models have the advantage to foUow a reliable measure of credit risk, that is the firm value, reduced-form approach overcomes the Umitatimi in which the balance sheet is not the unique indicator of the default prediction. 

Asset-swap pricing is commonly applied to credit-default swaps, especially by risk management departments seeking to price the transactions held on credit traders book. A par asset swap typically combines an interest rate swap with the sale of an asset, such as a fixed-rate corporate bond, at par and with no interest accrued. The coupon on the bond is paid in return for LIBOR plus, if necessary, a spread, known as the asset-swap spread. This spread is the price of the asset swap. It is a function of the credit risk of the underlying asset. That makes it suitable as the basis for the price payable on a credit default swap written on that asset. 

An asset swap is a package that combines an interest-rate swap with a cash bond, the effect of the combined package being able to transform the interest-rate basis of the bond. Typically, a fixed-rate bond will be combined with an interest-rate swap in which the bond holder pays fixed coupon and received floating coupon. The floating coupon will be a spread over LIBOR (see Choudhry et al. 2001). This spread is the asset-swap spread and is a function of the credit risk of the bond over and above interbank credit risk. Asset swaps may be transacted at par or at the bond s market price, usually par. This means that the asset swap value is made up of the difference between the bond s market price and par, as well as the difference between the bond coupon and the swap flxed rate. 

The Das-Tufano (DT) model is an extension of the JLT model. The model aims to produce the risk-neutral transition matrix in a similar way to the JLT model however, this model uses stochastic recovery rates. The final risk neutral transition matrix should be computed from the observable term structures. The stochastic recovery rates introduce more variability in the spread volatility. Spreads are a function of factors that may not only be dependent on the rating level of the credit as in practice, credit spreads may change even though credit ratings have not changed. Therefore, to some extent, the DT model introduces this additional variability into the risk-neutral transition matrix. 

As stated above, the hazard and risk assessment and allocation may be concurrent activities or allocation may in some circumstances take place prior to hazard and risk assessment. Decisions on the allocation of safety functions to safety layers are often taken on the basis of what has been found to be practicable by the user organization. Established industry good practice should also be taken Into account. Decisions will then be taken on the safety instrumented systems, assuming credit for the other safety layers. For example, where relief valves have been installed and these have been designed and installed according to industry codes, it may then be decided that these are adequate on their own to achieve adequate risk reduction. Safety instrumented systems would then only limit pressure where size or performance of the relief valve(s) was insufficient for the application or release to the atmosphere is to be prevented. 

Step 1 - Complete the LOPA without taking any credit for the SIF. First, determine the initiating events from HAZOP/What-if/EMEA study. Next, evaluate frequencies of all initiating events from company database and industry experience. Then, determine the probability that each IPL will function successfully from an industrial database. PFO yg of some typical protection layers are (CCPS, 2000) BPCS control loop = 0.10 Operator s response to alarm = 0.10 Rehef safety valve = 0.01 to 0.001 and vessel failure probability at maximum design pressure = 10 ". Finally, compare the calculated risk with the tolerable risk target... 

As discussed above, vanilla swap rates are often quoted as a spread that is a function mainly of the credit spread required by the market over the risk-free government rate. This convention is logical, because government bonds are the principal instrument banks use to hedge their swap books. It is unwieldy, however, when applied to nonstandard tailor-made swaps, each of which has particular characteristics that call for particular spread calculations. As a result, banks use zero-coupon pricing, a standard method that can be applied to all swaps. 

NOTE 2 Where a detailed hazard analysis of the BPCS demonstrates that the control and protective elemertts within the BPCS are functionally independent, it may be possible to conclude that a failure in the controlling part has a sufficiently low probability of causing the failure of the protective function. In such cases, it may be appropriate to take credit for the BPCS as a protection layer, even if the BPCS can initiate the process hazard. In accordance with ANSI/ISA-84.00.01-2004-1, Clause 9, the risk reduction claimed for the BPCS as a protection layer must be less than or equal to 10. 

As per lEC 61511-3 2003 Clause 9.4.3, operator action as part of safety instrument functions (SIFs) can be credited with a level of risk reduction greater than 10 when the system from the sensor to the final element can be designed and evaluated as an SIS per the requirements of lEC 61511. A typical automated SIS, popularly known as an industrial automation and control system (LACS), from the sensor to the final element can be conceived, as shown in Fig. VIII/1.4-1 or Fig. VII/1.3-1 where the main constituents are sensor, logic solver, and final element. When an operator action such as through the display/alarm is necessary this needs to be as shown in Fig. XI/2.4.3-1. 

In a simple LOPA using a conservative approach, unless there is complete independence in how basic process control functions are implemented through the BPCS, no credit can be taken for any risk reduction provided by a control or alarm function implemented through the BPCS as a protection layer if a BPCS failure also forms part of an initiating event. However, this conservative approach may be relaxed if it can be demonstrated that there is sufficient independence to allow credit to be taken for both. This issue is discussed in Sections 9.4 and 9.5 of BS EN 61511-1 and BS EN 61511 -2. The reader is referred to these sources for a more detailed discussion. Systematic factors such as security, software, design errors and human factors should also be considered. 

You could respond to these queries by exploring the risks that continually circulating cards - electronically blocked or not - still pose to the creditor, or whether or not the blocking of the credit card does in fact mark the passing of a definitive threshold (it does not). However, I suggest that the third and fourth posts point towards perhaps the most valuable function served by a creditor s demand for their credit card that the questions generated by this demand might prompt the borrower to contact the creditor - as, in fact, both these borrowers did (even if, as in the third post, the question in fact remains unresolved). 

In this chapter we review credit ratings and their function, and then go on to consider the main factors involved in corporate bond credit analysis. The second part of this chapter looks at measuring bond returns and spreads, which are necessary if one is assessing the relative value of holding one bond position vis-a-vis another position, or a risk-free investment. 

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