Chapter 11 - Estimating Parameters Required for Credit Risk Modeling

Abstract

Accurate estimates of credit risk are critical to the determination of profitability because returns are small relative to the risks taken. This chapter estimates the parameters required for credit risk modeling. The key parameters that define the risk of an individual credit exposure are the default probability, the exposure at default, and the loss in the event of default. Default rates can be developed either from market-based measures or from historical default rates associated with risk ratings. To ensure consistency in assigning risk ratings, rating philosophies must be specified and clearly communicated. Measures of exposure upon default can vary depending on the credit quality and maturity of commitments. Determination of loss in the event of default varies depending on whether the loan is senior or subordinated and secured or unsecured, and whether losses occur at the time of downturns in the economy. Judgments are required in defining default events and exposures, and in calculating economic loss. To calculate possible levels of portfolio loss, it is necessary to measure the extent to which individual companies may default at the same time. Default correlations are the key parameters needed to determine overall portfolio credit risk.