Welcome to the second issue of the fifteenth volume of The Journal of Credit Risk, which contains three original research papers.
The first paper, “A consumer credit risk structural model based on affordability: balance at risk”, by Marcelo S. Perlin, Marcelo B. Righi and Tiago P. Filomena, introduces an approach designed for personal credit risk, with possible applications in risk assessment and optimization of debt contracts. They define a structural model related to the financial balance of an individual, allowing for cashflow seasonality and deterministic trends in the process. Based on the proposed model, they develop risk measures associated with the probability of default rates conditional on time. This formulation is best suited to short-term loans, where the dynamics of individuals’ cashflow, such as seasonality and uncertainty, can significantly impact future default rates. In the empirical section of this paper, they illustrate an application by estimating risk measures using simulated data. They also present the specific case of optimization of a financial contract, where, based on an estimated model, they find the yield rate/time to maturity pair that maximizes the expected profit or minimizes the default risk of a short-term debt contract.
In “Wrong-way risk of interest rate instruments” Ramzi Ben-Abdallah, Michele Breton and Oussama Marzouk look at Wrong way risk (WWR). Wrong-way risk arises when the value of a financial transaction is adversely correlated with the creditworthiness of the counterparty. This paper investigates WWR effects on the pricing of counterparty credit risk for interest rat instruments.These effects are captured via the correlations between the default of the counterparty and the two relevant market risk factors, namely the level and the volatility of the instantaneous spot interest rate. They consider an interest rate model featuring unspanned stochastic volatility behavior in order to analyze the effects of correlations on both volatility-insensitive instruments (interest rate swaps) and volatility-sensitive products (interest rate caps and floors). They also investigate the impact of correlation on the gap risk in collateralized instruments. The authors’ empirical findings show that the wrong-way effect induced by the dependence between the interest rate volatility and the default intensity is generally small, even for volatility-sensitive derivatives. However, a dependence between the interest rate level and the default intensity has a sizable impact on counterparty risk.
And our final paper “A statistical technique to enhance application scorecard monitoring”, from Nico Kritzinger and Gary Wayne van Vuuren looks at application scoring. This plays a critical role in determining the future quality of a lender’s book. It is therefore important to monitor the performance of an application score card to ensure it performs as expected. Attention has so far been focused on application scorecard modeling and assembly techniques. An area that has received less consideration is application scorecard implementation. Performance measures on the accepted population appear to change in predictive power after the implementation of an application scorecard. This paper introduces and demonstrates a statistical measure to track the performance of the accepted population after the point of implementation on a comparable basis against the development window of the application scorecard.
We hope you enjoy these papers.
This paper investigates wrong-way risk effects on the pricing of counterparty credit risk for interest rate instruments.
Application scoring plays a critical role in determining the future quality of a lender’s book. It is therefore important to monitor the performance of an application scorecard to ensure it performs as expected.