RSK4804
ASSIGNMENT 1 2025
UNIQUE NO. 865733
DUE DATE: 30 MAY 2025
, RSK4804
Assignment 1 2025
Question 1
(a) Explain the two most important drivers of credit risk and how those relate to
the probability of default (PD).
Credit risk arises when there is a possibility that a borrower may fail to fulfill its debt
obligations. One crucial measure of credit risk is the probability of default (PD), which
is the likelihood that the borrower will default on their debt within a specified time period.
Two of the key factors influencing PD are:
1. Borrower-specific financial health: This includes the overall financial condition
of the borrower. Key metrics such as liquidity, profitability, leverage, and cash
flow sufficiency provide insight into the borrower's ability to meet its debt
obligations. A borrower with strong financial health (e.g., high liquidity, low debt-
to-equity ratio, and a robust business model) typically has a lower PD. Credit
rating models like Altman’s Z-score use these financial indicators to assess
default risk.
2. Macroeconomic conditions: The state of the broader economy significantly
affects the PD. Factors such as interest rates, inflation, GDP growth, and
unemployment rates play a vital role. During economic downturns, borrowers
may face lower revenues, reduced consumer spending, and restricted access to
credit, which can increase the PD. Conversely, during periods of economic
growth, the PD typically decreases, as businesses tend to perform better and
face fewer financial stresses.
ASSIGNMENT 1 2025
UNIQUE NO. 865733
DUE DATE: 30 MAY 2025
, RSK4804
Assignment 1 2025
Question 1
(a) Explain the two most important drivers of credit risk and how those relate to
the probability of default (PD).
Credit risk arises when there is a possibility that a borrower may fail to fulfill its debt
obligations. One crucial measure of credit risk is the probability of default (PD), which
is the likelihood that the borrower will default on their debt within a specified time period.
Two of the key factors influencing PD are:
1. Borrower-specific financial health: This includes the overall financial condition
of the borrower. Key metrics such as liquidity, profitability, leverage, and cash
flow sufficiency provide insight into the borrower's ability to meet its debt
obligations. A borrower with strong financial health (e.g., high liquidity, low debt-
to-equity ratio, and a robust business model) typically has a lower PD. Credit
rating models like Altman’s Z-score use these financial indicators to assess
default risk.
2. Macroeconomic conditions: The state of the broader economy significantly
affects the PD. Factors such as interest rates, inflation, GDP growth, and
unemployment rates play a vital role. During economic downturns, borrowers
may face lower revenues, reduced consumer spending, and restricted access to
credit, which can increase the PD. Conversely, during periods of economic
growth, the PD typically decreases, as businesses tend to perform better and
face fewer financial stresses.
