Question

20.1

Explain the importance of credit risk pricing. What are the various factors influencing credit risk pricing?

Answer 1

The quantification of credit risk is the method of assigning the probability of default risk to measurable and comparable numbers, and the term is a major frontier in modern finance. The factors influencing credit risk vary from unique borrower requirements to market-wide considerations. The idea is that liabilities can be objectively valued and predicted to help protect the lender against financial loss.

Several major variables are considered when evaluating credit risk: the borrower's financial health; the extent of the effects of a default (for the borrower and the lender); the duration of the credit extension; historical trends in default rates; and a number of macroeconomic factors, such as economic growth and interest rates.

Factors that influence credit risk pricing:

1. Probability of Default:

It communicates the risk that the creditor does not maintain the financial capacity to make scheduled debt payments. The default rate for individual borrowers is often interpreted as a combination of two factors: the debt-to-income ratio and the credit score.

2. Loss Given Default:

Imagine two borrowers with identical credit scores and identical debt-to-income ratios. The first borrower takes a $5,000 loan, and the second borrows $500,000. Even if the second individual has 100 times the income of the first, their loan represents a greater risk. This is because the lender stands to lose a lot more money in the event of default on a $500,000 loan. This principle underlies the loss given default, or LGD, factor in quantifying risk.

3. Exposure at Default:

EAD is an assessment of the total loss exposure a lender is exposed to at any point in time. Even though EAD is almost always used in reference to a financial institution, the total exposure is an important concept for any individual or entity with extended credit.

EAD is based on the idea that risk exposure depends on outstanding balances that can accrue before default. For example, for loans with credit limits, such as credit cards or lines of credit, risk exposure estimates should include, not just current balances, but also the potential increase in the account balances that might happen before the borrower defaults.

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