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
Exposure, Default and Recovery Rates
In order to understand default risk, we will analyze the its key components: Default arrival, exposure at default, and loss given default.
Expected Loss, Unexpected Loss, and Loss Distribution
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.
Understanding Recovery Rates
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.
Factors Affecting Recovery Rates
It is practically impossible to accurately predict the recovery rates. There are various factors that will affect the recovery rates of a defaulted loan.
Using Beta Distribution for Estimating Recovery Rates
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.