Credit risk — the risk of loss from a borrower or counterparty failing to meet their obligations — represents the largest risk for most financial institutions. FRM candidates must deeply understand credit risk measurement and management.

The Building Blocks: PD, LGD, and EAD

Probability of Default (PD): The likelihood a borrower defaults within a given period. Estimated using:

  • Internal rating models and scorecards
  • Market-based models (Merton model, KMV)
  • Statistical models (logistic regression, machine learning)

Loss Given Default (LGD): The fraction of exposure lost if default occurs. LGD = 1 - Recovery Rate. Influenced by collateral, seniority, and jurisdiction.

Exposure at Default (EAD): The total exposure when default happens. For revolving facilities, includes drawdown of unused commitments.

Expected vs Unexpected Loss

  • Expected Loss (EL) = PD × LGD × EAD — covered by provisions/reserves
  • Unexpected Loss (UL) — the volatility around EL, covered by capital

Credit Risk Models

Structural Models (Merton, KMV)

  • Model default as the firm's asset value falling below its debt obligations
  • Equity is a call option on the firm's assets
  • Distance-to-Default predicts default probability

Reduced-Form Models (Jarrow-Turnbull, Duffie-Singleton)

  • Model default as a random event driven by a hazard rate
  • Calibrated to market prices (CDS spreads, bond spreads)
  • Don't explain why default happens, only when

Portfolio Credit Risk Models

  • CreditMetrics: Simulates rating migrations and defaults using correlation
  • CreditRisk+: Actuarial approach focusing on default events
  • KMV Portfolio Manager: Uses asset correlations from Merton framework

Basel Credit Risk Framework

Under Basel III, banks choose between:

  • Standardized Approach: Uses external ratings for risk weights
  • Foundation IRB: Bank estimates PD, supervisor provides LGD and EAD
  • Advanced IRB: Bank estimates PD, LGD, and EAD

Counterparty Credit Risk

For derivatives and repos, counterparty credit risk requires:

  • CVA (Credit Valuation Adjustment): Adjusting derivative values for counterparty default risk
  • Central Clearing: Using CCPs to reduce bilateral counterparty exposure
  • Netting and Collateral: Reducing exposure through close-out netting and margin requirements

Master credit risk with our comprehensive practice questions!