,RSK4804 Assignment 1 (COMPLETE ANSWERS) Semester 1 2025 - DUE 30
May 2025;100% CORRECT AND TRUSTED SOLUTIONS
Question 1 [10]
a.
Explain the two most important drivers of credit risk and how those relate to the
probability of default (PD). (5)
Credit risk refers to the possibility that a borrower or counterparty will
fail to meet their obligations in accordance with agreed terms. Two of
the most important drivers of credit risk are:
1. Creditworthiness of the Borrower
This refers to the financial health, credit profile, and repayment
ability of the borrower. It includes factors such as:
Historical payment behaviour (e.g., past defaults or arrears)
Current and projected income or cash flows
Debt servicing capacity (e.g., interest coverage ratio, debt-to-
income ratio)
Credit rating or internal risk grade (by external rating agencies
or internal models)
Relation to PD:
A borrower with weak creditworthiness has a higher probability of
default (PD) because they are more likely to encounter financial
difficulties that impair their ability to repay the debt. Conversely, a
borrower with strong credit fundamentals will have a lower PD.
2. Macroeconomic and Industry Conditions
, External environmental factors can significantly affect a borrower’s
ability to repay debt. These include:
Economic growth or recession
Interest rate environment
Inflation trends
Sector-specific dynamics (e.g., oil price shocks for energy
companies)
Relation to PD:
Adverse macroeconomic or industry-specific events can increase
systemic and idiosyncratic risks, thus increasing the likelihood of
borrower default. For example, in a recession, consumer and business
incomes fall, resulting in higher PDs across the board, especially for
lower-rated credits.
In summary, creditworthiness assesses the borrower’s individual risk of
default, while macroeconomic/industry conditions influence the
external environment affecting that risk. Both are core inputs in
estimating Probability of Default (PD), which is central to pricing,
reserving, and capital allocation in credit risk management.
b.
As head of credit risk at Daspoort Investment Bank, you are considering approval
of a five-year credit asset (business term loan) with a bullet (balloon) repayment at
the end of a term. The term loan shows a marginal probability of default of 1.3%,
1.5%, 1.2%, 1.7%, and 2.2% for each of the five years, respectively. How would
you find the cumulative probability of default over the five-year period for pricing
purposes? (5)
When a credit asset has a bullet (balloon) repayment structure, the entire
principal is repaid at maturity, and thus the lender is exposed to credit risk
throughout the term. To evaluate pricing and risk, the cumulative probability of
default (CPD) over the 5-year period must be calculated.
May 2025;100% CORRECT AND TRUSTED SOLUTIONS
Question 1 [10]
a.
Explain the two most important drivers of credit risk and how those relate to the
probability of default (PD). (5)
Credit risk refers to the possibility that a borrower or counterparty will
fail to meet their obligations in accordance with agreed terms. Two of
the most important drivers of credit risk are:
1. Creditworthiness of the Borrower
This refers to the financial health, credit profile, and repayment
ability of the borrower. It includes factors such as:
Historical payment behaviour (e.g., past defaults or arrears)
Current and projected income or cash flows
Debt servicing capacity (e.g., interest coverage ratio, debt-to-
income ratio)
Credit rating or internal risk grade (by external rating agencies
or internal models)
Relation to PD:
A borrower with weak creditworthiness has a higher probability of
default (PD) because they are more likely to encounter financial
difficulties that impair their ability to repay the debt. Conversely, a
borrower with strong credit fundamentals will have a lower PD.
2. Macroeconomic and Industry Conditions
, External environmental factors can significantly affect a borrower’s
ability to repay debt. These include:
Economic growth or recession
Interest rate environment
Inflation trends
Sector-specific dynamics (e.g., oil price shocks for energy
companies)
Relation to PD:
Adverse macroeconomic or industry-specific events can increase
systemic and idiosyncratic risks, thus increasing the likelihood of
borrower default. For example, in a recession, consumer and business
incomes fall, resulting in higher PDs across the board, especially for
lower-rated credits.
In summary, creditworthiness assesses the borrower’s individual risk of
default, while macroeconomic/industry conditions influence the
external environment affecting that risk. Both are core inputs in
estimating Probability of Default (PD), which is central to pricing,
reserving, and capital allocation in credit risk management.
b.
As head of credit risk at Daspoort Investment Bank, you are considering approval
of a five-year credit asset (business term loan) with a bullet (balloon) repayment at
the end of a term. The term loan shows a marginal probability of default of 1.3%,
1.5%, 1.2%, 1.7%, and 2.2% for each of the five years, respectively. How would
you find the cumulative probability of default over the five-year period for pricing
purposes? (5)
When a credit asset has a bullet (balloon) repayment structure, the entire
principal is repaid at maturity, and thus the lender is exposed to credit risk
throughout the term. To evaluate pricing and risk, the cumulative probability of
default (CPD) over the 5-year period must be calculated.
