Risk, Credit Ratings and Financial Crisis.pptxVIP

Dr. Edmund CannonRisk, Credit Ratings and Financial DerivativesContentsMeasuring risk and credit ratingsRisk pooling (diversification)SecuritisationCDOsCDSsCredit Ratingse.g. Moody’sGradeExpected 10-year lossCommentAaa0.01%Highest gradeInvestment GradeAa0.06% - 0.22%Very low riskA0.39% - 0.99%Low riskBaa1.43% - 3.36%Moderate riskBa5.17% - 9.71%Questionable qualitySpeculative Grade(Junk bonds)B12.21% - 19.12%Poor qualityCaa35.75%Extremely poorCa, CPossibly in defaultProblems with the credit rating industryRatings agencies have quasi-official statusie when a bank justifies the risk on its balance sheet to a regulator it uses a recognised agency’s ratings.Very few firms (Moody’s, Fitch, Standard Poors)ReputationNeeds to be officially recognised.Too much reliance on ratings agencies.Agencies are paid by the issuer of an asset (ie the borrower) not the purchaser of the asset (the lender). This creates an incentive problem.Simple ModelIn this model there are two borrowers, X and Y.Each borrower will eitherRepay a loan of ￡100 (probability of 0.9)Default and repay nothing (probability of 0.1)(This model is not very realistic, but the maths is simple.)We start by assuming that whether or not X repays is independent of whether or not Y repays.Simple Model (continued)No correlationBorrower XBorrower Y Default prob = 0.1Repay prob = 0.9Default prob = 0.10.010.09Repay prob = 0.90.090.81So there are three possibilities:Both borrowers repay (probability 0.81)Just one borrower repays (probability 0.18 = 0.09 + 0.09)Both borrowers default (probability 0.01)Loan Y has the same characteristics as Loan X.Each saver gets half of the money paid into the mutual fund.Discussion of ModelBy pooling risky assets it is possible to reduce overall risk.In the example the risky assets were uncorrelated.It is still possible to reduce risk if assets are positively correlated (so long as they are not perfectly correlated).Overall risk can be reduced even more if the assets are negatively correlat