RSK4804 Assignment 1 2025 (Answer Guide) - Due 30 May 2025

RSK4804 Assignment 1 2025 (Answer Guide) - Due 30 May 2025 Question 1 [10] a. Two Most Important Drivers of Credit Risk and Their Relationship to Probability of Default (PD) [5] The two most important drivers of credit risk are: 1. Creditworthiness of the Borrower: This refers to the borrower's financial health, historical repayment behavior, and overall ability to meet debt obligations. Factors such as income stability, debt levels, credit history, and financial ratios (e.g. debt-to-equity or interest coverage ratios) are evaluated. A weaker credit profile increases the likelihood that the borrower will default on their obligations, thus increasing the Probability of Default (PD). 2. Macroeconomic Environment: Broader economic conditions such as interest rates, inflation, GDP growth, and unemployment rates significantly influence the ability of borrowers to repay loans. In a declining economic environment (e.g., recession), businesses and individuals may struggle with cash flow or revenue, raising the overall risk of default. As such, economic downturns tend to push the PD higher across sectors and borrowers. These two drivers interact closely—borrowers with marginal creditworthiness are particularly vulnerable to negative shifts in the macroeconomic environment, leading to an elevated PD. b. Calculation of the Cumulative Probability of Default over a 5-Year Period [5] To find the cumulative probability of default (cumulative PD) over the five-year period, assuming the defaults are independent across years and that no recovery occurs after default, you can use the following formula: Cumulative PD = 1 - ∏(1 - Marginal PDᵢ), for i = 1 to 5 Given marginal PDs: - Year 1: 1.3% → 0.013 - Year 2: 1.5% → 0.015 - Year 3: 1.2% → 0.012