Risk, credit indicators

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. 

A Z-spread can be calculated relative to any benchmark spot rate curve in the same manner. The question arises what does the Z-spread mean when the benchmark is not the euro benchmark spot rate curve (i.e., default-free spot rate curve) This is especially true in Europe where swaps curves are commonly used as a benchmark for pricing. When the government spot rate curve is the benchmark, we indicated that the Z-spread for nongovernment issues captured credit risk, liquidity risk, and any option risks. When the benchmark is the spot rate curve for the issuer, for example, the Z-spread reflects the spread attributable to the issue s liquidity risk and any option risks. Accordingly, when a Z-spread is cited, it must be cited relative to some benchmark spot rate curve. This is essential because it indicates the credit and sector risks that are being considered when the Z-spread is calculated. Vendors of analytical systems such Bloomberg commonly allow the user to select a benchmark. 

Another indicator of credit risk is the credit risk premium the spread between the yields on corporate bonds and those of government bonds in the same currency. This spread is the compensation required by investors for holding bonds that are not default-free. The size of the credit premium changes with the market s perception of the financial health of individual companies and sectors and of the economy in general. The variability of the premium is illustrated in FIGURES 10.2 and 10.3 on the following page, which show the spreads between the U.S.-dollar-swap and Treasury yield curves in, respectively, February 2001 and February 2004. 

LOPA is a simplified risk assessment to determine if there are sufficient IPLs against an accident scenario. As illustrated in Fig. 1, many types of protection layers can be considered against an unwanted accident. The thickness of the arrows represented in Fig. 1 indicates the frequency of the specified consequence for the initiating event. The results of LOPA can be used for the decision-making for numerical criteria and the number of IPL credits althou LOPA does not suggest which IPLs to add or which design to choose [William G. Bridges. 2001]. 

After the introduction of indices on credit portfolios, investors became interested in identifying different risk/reward profiles (as in a synthetic... 

The CRAs play a key role in the operation of credit markets, and their rating is an indicator of credit quality. However, the ratii is an opinion based on the CRAs methodology. The CRAs usually make it clear that their credit ratii is a measure of credit quality and is not an investment recommendation and does not capture the risk of a decline in market value or liquidity of the product. It remained important for investors and originators to do s nificant amounts of their own independent credit analysis, due diligence, and assess the market risk and liquidity risk associated with an instmment rather, than rely purely on CRAs rating. Unfortunately, many investors did not perform such due diligence. 

The spread that is selected is an indication of the relative value of the bond and a measure of its credit risk. The greater the perceived risk, the greater the spread should be. This is best illustrated by the credit structure of interest rates, which will (generally) show AAA- and AA-rated bonds trading at the lowest spreads and BBB-, BB- and lower-bonds trading at the highest spreads. Bond spreads are the most commonly used indication of the risk-return profile of a bond. 

Credit must correctly and continuously assess the ability of customers to pay fully and on time, and communicate this information to management promptly. A few bad debts may an acceptable risk associated with aggressive selling, and no bad debts may indicate too cautious an approach, but many bad debts can injure the company s financial performance, which is unacceptable. Credit insurance may be a reasonable option if management is uncomfortable with the credit worthiness of some larger but riskier customers. 

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