RSK4804
ASSIGNMENT 1 2025
UNIQUE NO. 865733
DUE DATE: 30 MAY 2025
, Question 1(a): Two Key Drivers of Credit Risk and Their Relationship to
Probability of Default (PD)
[5 Marks]
Credit risk refers to the possibility that a borrower will not fulfill their repayment
obligations. The Probability of Default (PD) is a key measure that estimates the
likelihood of such a default within a specific period, typically one year. Two major drivers
of credit risk that directly influence PD are:
1. Borrower’s Financial Condition
The financial health of a borrower is a critical determinant of their creditworthiness. Key
financial indicators such as liquidity ratios, profitability margins, and leverage (e.g., debt-
to-equity ratio) are used to assess whether a borrower can meet repayment obligations.
Strong financials usually indicate a lower PD, while poor cash flow or excessive debt
suggests a higher risk of default. Credit scoring tools like the Altman Z-score or the
IRB (Internal Ratings-Based) approach are commonly used to quantify this risk.
2. Macroeconomic Conditions
Wider economic factors significantly impact borrowers’ ability to repay loans. Indicators
like interest rates, GDP growth, inflation, and unemployment rates influence both
corporate and consumer financial stability. For instance, during a recession, reduced
income and higher borrowing costs can lead to increased defaults, especially in
vulnerable sectors such as retail and construction. This results in a higher aggregate
PD across portfolios.
ASSIGNMENT 1 2025
UNIQUE NO. 865733
DUE DATE: 30 MAY 2025
, Question 1(a): Two Key Drivers of Credit Risk and Their Relationship to
Probability of Default (PD)
[5 Marks]
Credit risk refers to the possibility that a borrower will not fulfill their repayment
obligations. The Probability of Default (PD) is a key measure that estimates the
likelihood of such a default within a specific period, typically one year. Two major drivers
of credit risk that directly influence PD are:
1. Borrower’s Financial Condition
The financial health of a borrower is a critical determinant of their creditworthiness. Key
financial indicators such as liquidity ratios, profitability margins, and leverage (e.g., debt-
to-equity ratio) are used to assess whether a borrower can meet repayment obligations.
Strong financials usually indicate a lower PD, while poor cash flow or excessive debt
suggests a higher risk of default. Credit scoring tools like the Altman Z-score or the
IRB (Internal Ratings-Based) approach are commonly used to quantify this risk.
2. Macroeconomic Conditions
Wider economic factors significantly impact borrowers’ ability to repay loans. Indicators
like interest rates, GDP growth, inflation, and unemployment rates influence both
corporate and consumer financial stability. For instance, during a recession, reduced
income and higher borrowing costs can lead to increased defaults, especially in
vulnerable sectors such as retail and construction. This results in a higher aggregate
PD across portfolios.
