Default risk can be defined as the risk that the counterparty to a transaction does not honour its obligation. Default could be both in terms on monetary and non-monetary terms, and it’s a part of every transaction.
Foundations of Credit Risk Modelling
In order to understand default risk, we will analyze the its key components: Default arrival, exposure at default, and loss given default.
While the terms expected loss and unexpected loss are commonly used in risk management, it is important to have a clear understanding of what they actually mean.
The recovery rates are a crucial element for calculating credit risk. The loss given default of an asset or a portfolio is calculated as 1 minus the recovery rate.
It is practically impossible to accurately predict the recovery rates. There are various factors that will affect the recovery rates of a defaulted loan.
Most of the people use the beta distribution to model recovery rates. In probability theory and statistics, the beta distribution is a family of continuous probability distributions defined on the interval (0, 1) parameterized by two positive shape parameters, typically denoted by alpha and beta.