MANAGEMENT OF CREDIT RISK

AND EXCHANGE RATE RISK WITH

EXAMPLES

CREDIT RISK MANAGEMENT

“Probability of loss from a credit transaction” is the

general definition of credit risk. “Credit Risk is most

simply defined as the potential that a borrower or

counter-party will fail to meet its obligations in

accordance with agreed terms”.

Risk where borrower cannot pay interest rat nor

principle according to contracts.

• It involves identifying and analyzing risk in a credit

transaction

• It revolves around measuring, managing and controlling

credit risk in the context of an organization’s credit

philosophy and credit appetite.

• It is predominantly concerned with probability of default.

• Depending on the risk manifestations of an exposure, an

exist route remains a usual option through the sale of

assets/securitization

• Statistical tools like VaR (Value at Risk), CVaR (Credit

Value at Risk), duration and simulation techniques, etc.

form the core of credit risk management

• It is forward looking in its assessment, looking, for

instance, at a likely scenario of an adverse outcome in the

business

For Example

A consumer may fail to may a payment due on a

mortgage loan, credit card, or any other loan.

An insolvent insurance company does not pay a policy

obligation

An insolvent bank won’t return funds to a depositor

A government grants bankruptcy protection to an

insolvent consumer or business

Framework of Credit risk management

Control of individual loans

Risk management of the loan portfolio

Control of individual loans

Credit worthiness of customers

1) ability to pay

2) willingness to pay

Amount of credit granted

1) When creditworthiness is good, amount of credit can

be increased.

How to measure creditworthiness

Probability of default (PD)

• Probability in which customers will default in certain time horizon.

• PD can be calculated by using data of customers

• PD is assigned to each customer

How to calculate:

Logistic regression model is usually used to calculate probability of default.

Data should have the results where customers are default or not default

Logistic regression model produces outputs between 0 and 1 from data.

These outputs are considered as probability.

Logistic regression model

• PD= exp(βX)/(1+exp(βX))

• X : risk factors such as Income, occupation, age, sex,

credit history etc.

and Revenue profits, stock price, capital ratio, etc.

β: Coefficients to risk factors.

Credit Rating:

Rating is assigned to each customer according to

probability of default and other information of customers

AAA is usually the highest rating

C- is usually the lowest rating

Risk management of the loan portfolio

Basic concept:

• Avoid the concentration in the portfolio.

• Correlation over expected defaults among customers

should be controlled

• Do not put all eggs in the same basket

In assessing credit risk from a single

counter party, an institution must consider

three issues.

• Default probability: What is the likelihood that the

counterparty will default on its obligation either over the

life of the obligation or over some specified horizon, such

as a year?

• Credit exposure: In the event of a default, how large will

the outstanding obligation be when the default occurs?

• Recovery Rate: In the event of a default, what fraction of

the exposure may be recovered through bankruptcy

proceeding or some other form of settlement?

Types of Credit Risk Management:

• Credit Default Risk: The risk of loss arising from a debtor

being unlikely to pay its loan obligations in full or the debtor is

more than 90 days past due on any material credit obligation. It

including loans, securities and derivatives.

• Concentration Risk: The risk associated with any single

exposure or group of exposures with the potential to produce

large enough losses to threaten a bank’s core operations. It

may arise in the form of single name concentration or industry

concentration.

• Country Risk: The risk of loss arising form a sovereign state

freezing foreign currency payments r when it defaults on its

obligations. This type of risk prominently associated with the

country’s macroeconomic performance and its political stability.

Mostly all banks today practice credit risk management.

They understand the importance of credit risk management

and think of it as a ladder to growth by reducing their

NPA’s. Moreover they are now using it as a tool to succeed

over their competition because credit risk management

practices reduce risk and improve return capital.

Credit Risk Management philosophy

Goals of Credit Risk Management

Maintaining risk-return discipline by keeping risk exposure within

acceptable parameters.

Fixing proper exposure limits, keeping in view the risk philosophy and

risk appetite of the organization.

Handling credit risk both on an “entire portfolio” basis and on an

“individual credit or transaction” basis.

Maintaining an appropriate balance between credit risk and other risks

Creating and maintaining a respectable and credit risk management

culture to ensure quality credit portfolio.

Keeping “consistency and transparency “as the watchwords in credit risk

management

The Credit Risk Management Process

The risk management process has four

components:

Risk Identification.

Risk Measurement.

Risk Monitoring.

Risk Control.

Meaning of Exchange Rate Risk

• Risk of fluctuating value of a currency over time

• If the time and size of cash inflows in one currency does not match the time and size of cash outflows in the same currency, we face exchange rate risk

• Impacts dollar value of foreign currency cash inflows and foreign currency cash outflows

• If we have foreign currency cash inflows, we face risk of foreign currency depreciating against domestic currency

• If we have foreign currency cash outflows, we face risk of foreign currency appreciating against domestic currency

Types of Exchange Rate Exposures

Transaction Exposure

Translation Exposure

Economic Exposure

Transaction Exposure

• Only companies engaged in global business

and doing transactions in foreign currency face

this risk

• Arises due foreign currency transactions of a

firm

• Arises from the possibility of incurring future

exchange gains/losses on transactions already

entered into and denominated in a foreign

currency.

Measuring Transaction Exposure

• Determine the projected net amount of inflows or outflows

in each foreign currency

• Determine the overall risk of exposure to these currencies

• To determine the amount of transaction exposure, keep in

mind the following:

• The net exposure of all subsidiaries combined

• Range of possible exchange rates

• Range of cash inflows and outflows

• Standard Deviation of currencies

• Correlations among currencies

Translation Exposure

• The exposure of the MNC’s consolidated financial

statements to exchange rate fluctuations

• If the assets/liabilities are translated at something other

than the historical exchange rates, the Balance Sheet will

be affected by fluctuations in currency values over time

Economic Exposure

• The extent to which the economic value of a company can decline

because of exchange rate changes

• Decline can be due to a decline in the level of expected cash flows or

an increase in the riskiness of these cash flows

• Overall effect of exchange rate changes in competitive relationships

between alternative foreign locations

• Extent of exposure depends on

• structure of markets for a firm’s product

• Price elasticity of demand for the product

• Availability of close substitutes for the product

• Even pure domestic firms may face economic exposure

Management of Transaction Exposure

• Foreign currency cash outflows

• Risk: Foreign currency may become more expensive/appreciate against domestic currency

• Strategy: Buy foreign currency futures, forwards, or call options

• Foreign currency cash inflows

• Risk: Foreign currency may become more cheap/depreciate against domestic currency

• Strategy: Sell foreign currency futures, forwards, or buy put options

Management of Economic Exposure

• Marketing Initiatives• Market Selection

• Pricing Strategy

• Product Strategy

• Promotion Strategy

• Production Initiatives• Product sourcing and input mix

• Plant location

• Raise Productivity

• Financial Initiatives

Marketing Initiatives

• Shall we pull out of a market that has been rendered unprofitable due to competition or shall we differentiate the product and concentrate on specific customers only?

• Shall we emphasize market share or profit margin in response to weak domestic currency?

• Shall we add/drop a product to our product line in response to exchange rate changes?

• Where to advertise?

Production Initiatives

• Outsource your inputs/raw materials/components in response to strong domestic currency

• Change input mix to reduce cost in response to strong domestic currency

• Shift production to weak currency area in response to strong domestic currency

• Raise productivity by cutting costs—produce the same number of units at a lower cost or produce more units at the same cost

Financial Initiatives

• Equate the sensitivity of costs and revenues to exchange

rate changes