What is Credit Risk?
Credit default risk is the risk that an obligor is unable to meet its financial obligations. In the event of a default of an obligor, a firm generally incurs a loss equal to the amount owed by the obligor less a recovery amount which the Firm recovers as a result of foreclosure, liquidation or restructuring of the defaulted obligor. All portfolios of exposures exhibit credit default risk, as the default of an obligor results in a loss.
Credit default risk is typically associated with exposures that are more likely to be held to maturity, such as corporate and retail loans and exposures arising from derivative portfolios.
How PARMS treats Default.
By treating the default rate as a discrete variable, a simplification of the continuous process is made. A convenient way of making default rates discrete is by assigning credit ratings to obligors and flapping default rates to credit ratings. Using this approach, additional information is required in order to model the possible future outcomes of the default rate. This can be achieved via a rating transition matrix that specifies the probability of keeping the same credit rating, and hence the same value for the default rate, and the probabilities of moving to different credit ratings and hence to different values for the default rate.
The discrete approach with "rating migrations and the continuous approach with a default rate volatility are different representations of the behavior of default rates. Both approaches achieve the desired end result of producing a distribution for the default rate.
It considers default rates as continuous random variables and incorporates the volatility of default rates in order to capture the uncertainty in the level of default rates.
In addition background factors which may cause the incidences of credit default to be correlated are taken into account. This may include factors like the state of the Economy. This s done through the use of default rate volatility and sector analysis rather than using default correlation as explicit inputs into the model.