RSK4804+FORMULAE (RSK4804) Assignment 01 Solutions

Question 1 Explain Probability of default and briefly discuss its uses. (10) Suggested solution It is a statistical percentage probability of a borrower defaulting√ and it is directly linked to credit grades √ Uses • Quantification of credit risk √ PD facilitates distinguishing the credit risk of different asset classes in a portfolio and judging the credit worthiness of the obligor. √ • Allocation of capital√ if the probability of default is high capital allocation is also high √ • Better credit risk pricing√. - higher probability of default (PD) means higher risk of default which means the risk premium has to be higher for example PD is the major risk driver in pricing credit default swaps √ • Client selection √ scientific study is used to derive PD using internal and external data by rating agencies. The information from rating agencies is used by financial firms as a benchmark in client selection√. • Credit quality √ it provide an insight into credit quality and enables better monitoring of high r