Technische Universität München Credit as an Asset Class - risklab

CHAPTER 2. CREDIT RISK TRANSFER
Interest-rates can be stipulated fixed or floating. In the case of floating interest-rates,
there is usually a market interest-rate which is used as benchmark (for example LIBOR 5 ).
The obligor has to pay the benchmark rate plus a spread. Furthermore, loans can be
granted unsecured or secured. Real estate or securities often serve as collateral.
Apart from the presented specifications, there are much more variations in designing
a loan contract since it is a private agreement and thus very flexible.
Loans can be classified into defaultable or risky loans and non-defaultable or (default)
risk-free 6 loans, dependent on the obligor’s credit quality. ”Defaultable” is a term used
for any kind of loan bearing credit risk, while a non-defaultable loan has no credit risk
exposure, since the obligor has the highest credit quality.
Risks related to Loans
Lenders and obligors are exposed to several risks. Besides credit risk, which is discussed in
Section 2.1.1, there are more risks inherent in loans. In the following, we give an overview
on the most important ones.
• Interest-rate risk– risk of a potential loss that could arise from a change of the market
interest-rates.
• Currency risk – risk of a potential loss that could arise from an adverse price change
of foreign currency.
• Inflation risk – risk of reduced real purchasing power of future payments driven by
inflation.
A loan is the oldest means of payment obligation and it is still an important source
of funding. Since loan contracts are often non-standardised, it is difficult or impossible to
trade single loans. In contrast, bonds enable investors to trade debt. They are described
in the following section.
2.2.2 Bonds
A bond is a securitised form of a loan. At the issuing of a bond, the bond holder or lender
buys the bond with a certain principal amount 7 from the issuer or borrower either at
par, with an agio or a disagio. 8 By issuing bonds, the borrower commits itself to make
stipulated payments comprising the repayment of the principal amount at maturity date
and interest or coupon payments at predefined coupon dates (for example annually or
semi-annually) to the bond holder.
Classification of Bonds
Analogous to loans, bonds can be classified into defaultable or risky bonds and non-
defaultable or (default) risk-free bonds. ”Defaultable bond” is a term for any kind of
5 LIBOR is the London InterBank Offered Rate. It represents the interest-rate between banks.
6 We use the term ”risk-free” if we consider a financial instrument to be default risk-free.
7 Analogue to loans, the principal amount is the amount which the issuer pays back at maturity and
it is the basis for calculating the interest payments. We will also denote it by nominal amount, notional
amount or simply notional.
8 The meaning of ”at par”, ”agio” and ”disagio” is explained in Section 2.2.1.
7