CREDIT RISK

4th ADVANCE
COURSE: ADVANCED TOPICS IN FINANCE
NAME: JUAN VLADIMIR SANCHEZ ACOSTA
PROFESSOR: EDMUNDO LIZARZABURU

2014

INDEX
Credit Risk
1. World history of credit
2. Introduction to credit risk
2.1.-Credit risk vs. Market risk
2.2.-Lenders
2.3.-Borrowers
2.4.-characteristics of credit products
2.4.1. - maturity
2.5.2.-specification of legal tender
2, 4, 3.-destination
2, 4, 4.-source of payments for repayment
2, 4, 5.-warranty requirements
2, 4, 6.-covenants required
2.4.7.-system characteristics amortization
3. - Banking credit risk

4. - Elements of Credit

4.1 Financial Assets

4.1.1 Illiquid assets

4.1.2 Assets exposed to credit risk

4.1.2.1 Loans

4.1.2.2 Lines of Credit

4.1.2.3 Borrowing obligations

4.1.2.4 Financial assets derived

4.1.2.4.1 Forwards

4.1.2.4.2 Future Contracts

4.1.2.4.3 Options Contracts

4.1.2.4.4 Swaps

4.2 Debtors

5.-Credit scoring

6. - Enterprise credit risk

7. - 5 C of credit

8.- Conclusions

9. Bibliographic references

1. - World History of credit

Throughout the entire evolution of credit risk and since its inception, the
concept of analysis and criteria used were as follows: since the beginning of
1930, the key analysis tool has been the balance. In early 1952, the analysis of
the income statements were changed, what mattered most were the profits of
the company. From 1952 to modern times, the criterion used was the cash flow.
Credit is given if a client generates sufficient cash to pay, since the credits are
not paid utility or inventories or less with good intentions, are paid cash.
The credit analysis is considered an art, as there is no rigid schemes and
instead is dynamic and requires creativity from the Official Credit or Business.
However, it is important to master the various techniques of credit analysis and
supplement it with a good deal of experience and judgment, so it is necessary
to have the necessary and sufficient information to enable us to minimize the
number of unknowns to be able to make the right choice.
2. Introduction to Credit Risk
Before making, any comment on it is necessary to know the variable and the
concept of risk involved and with which lived from day to day in a financial
institution
In very simple terms, there is risk in any situation where you do not know
exactly what will happen to the future. Risk is synonymous with uncertainty; it
is difficult to predict what will happen in the future.
It is therefore important to know the risk in the financial sector; most significant
financial decisions are based on predicting the future and not based on what
was expected, in that case will have made a bad decision.
There are people who refuse to accept the risks and those who are not so
reluctant, in all cases; the idea is to assume the least possible risk to the extent
of the possibilities.
However, it is good to know that the risk is not always bad; you can live with
through an incentive. Is be able to accept more risk to the extent that this is
paid (reward). That is why there is a direct relationship between risk and return,
which is why the relationship to higher risk, higher return is met.

Key factors that determine risk in financial institutions

Internal factors, which depend directly on the self-administration and / or ability
of executives from each company
External factors, which are independent of the administration, for example,
inflation, depreciation, climatic disasters, etc.

Introduction to Risk Analysis

An extremely important aspect in the management of credit risk is related to
the analysis and risk assessment and the classification of customers. These
processes require risk analysis of information sources, both internal and
external and specific systems.
Risk management can be addressed in a massive way or adopting qualitative
criteria. The mass management is possible when there are thousands of
millions of customers, meeting the client individually considered lacking or
devoid of excessive value.
In risk management, preventive or defensive mechanisms and healing
mechanisms can be adopted. Among the preventive processes, which aim to
avoid risk-taking over the company policy, prior customer research vigil risks,
business reports, financial analysis systems, control fall customer debt, control
systems limit the scoring. Mechanisms to ensure the recovery of debt in the
terms agreed with the customer, systems may include coverage, endorsements
and guarantees the bonds, credit insurance, the maturity notice systems,
proactive incident management, controls of recovery and legal actions.
Similarly, the risk manager must be aware of all phases of operation: the
definition monitor risk limits at the time of high customer control conditions
delivery and billing of the order, management of delivery notes, incidents in
turnover and control conditions and payment at maturity.

In a previous analysis phase should be measured and rate the risk, that,
analyzing and evaluating contingencies, quantifying which will assume the
client and what assessment has the same, assigning risk limits.
This management and risk analysis models, which are reaching ever-higher
degree of automation will apply. In this process of analyzing the credit
manager's solvency must be in contact not only with the financial department,
but also with the sales department, it must be noted that a sale is not
perfected until the time of collection, implying a coordination between the two
departments to seek agreements with customers, adequate coverage,
compliance with the limits assigned risk exceeded authorizations, etc.

To get to set a limit of risk, which is simply the result of the analysis must take
into account aspects such as:

Customer Rating

Implementation in the sector

Turnover
Its relevance to commercial company
Final Performance
Technical Solvency encrypted in its historical payment behavior in its external
behavior, the result of an economic analysis - financial ratios, balance sheet,
income statement, foreign companies specialized information, etc.
One of the techniques used in risk assessment for allocation of limits is the
scoring based on the application of statistical techniques of multivariate
analysis in order to determine the quantitative laws governing economic life of
the company. Thus, the behavior is determined by the variables with higher
predictive power given its correlation with the outcome, and the weight of each
of the variables within each risk considered, a score is assigned.
The rating is also used, applying statistical techniques of quantitative analysis
and expert opinion, granting the scoring function of the variables considered as

relevant in the analysis and risk assessment and weighting each of them, and
finally pool risks rated in homogeneous classes, segmenting the population into
groups of similar rating.
Once properly valued and weighted the variables according to the standard
test taken, and made the appropriate adjustments in coordination with the
sales department, the risk limit of the customer will be given by the maximum
economic smashing that may result in the company will be set.
New technologies applied to this field greatly facilitate the activity manager
allowing the automation of repetitive processes and enabling the allocation of
risk limits per customer in a reliable manner.

2.1.-Credit risk vs. Market risk

Market risk is the potential loss due to changes in market prices or values

Assessment time horizon : typically one day

Credit risk is the potential loss due to the nonperformance of a financial

contract, or financial aspects of nonperformance in any contract

Assessment time horizon: typically one year

Credit risk is generally more important than market risk for banks
Many credit risk drivers relate to market risk drivers, such as the impact

of market conditions on default probabilities

Differs from market risk due to obligor behavior considerations
The five Cs of Credit Capital, Capacity, Conditions, Collateral, and
Character.

Both credit and market risk models use historical data, forward looking models
and behavioral models to assess risks.
2.2.-Lenders
The banks provide financial intermediation, the process by which a group that
needs capital borrows funds from another group that has excess capital
available to invest. In organizing this transfer of capital between the two
groups, the bank uses deposits to fund the credit. Thus, mediation is a critical

process for promoting economic development. Banks accept deposits from a

group (depositors) and use those funds to provide credit products to another
group (borrowers).
Grant credit risk involved. Thus, banks assume this risk as a regular cost of
doing business. The banks are engaged in managing risks. Banks regularly
assess their experiences and incorporate lessons learned in business modifying
their existing policies and procedures or create new ones to mitigate credit risk.
However, despite all these efforts, recent events in the banking sector have
shown how demanding it can be management and credit risk analysis.
Banking activity is essential for both retailers to wholesale markets. There are
hundreds of local, regional and global banks that offer a variety of products and
services to meet the needs of the retail market (private clients, retail and small
and medium enterprises). In the wholesale market (loans to other banks, large
corporate groups and large global institutions).

Investment Banks
Investment banks often play the role of agent or financial intermediary firms.
Although they can make their own trading, providing investment advice to their
customers and grant loans to corporate customers, its main activity is to
organize the financing of equity and debt. Loans, bonds and other credit-on
behalf of their corporate clients.
Investment banks normally do not accept customer deposits, or extend credit
to retail customers, and in most cases, are not directly governed by bank
regulators.

External credit rating agencies

Although not technically lender, the external credit rating agencies play a
similar lenders assess the creditworthiness of borrowers several paper. The
difference between credit rating agencies and lenders is that the rating
agencies do not lend money.

Rating agencies assess the creditworthiness of borrowers and the listed debt
and credit ratings allocated to the borrowers and debt instruments issued. The
ratings are intended to provide an independent assessment of the general
creditworthiness of a borrower, based on a wide variety of risk factors.
Qualifications vary from the taller usually AAA credit rating or Aaa, indicating a
very high ability to repay the credit-to lower-rated - usually C or D, suggesting
that the bonus will not be paid or already was default- ratings investment
grade typically cover of AAA / Aaa to BBB / Baa and ratings with noninvestment grade are generally in the range of BB / Ba and C / D.
Grades with a Single-rating as AAA, BB and C - representing synthesis material
including quantitative, qualitative and legal information about the borrower
data, and communicate the results of the rating process to the public.

2.3.-Borrowers
Both retail and wholesale banks, differentiate between different types of
borrowers based on a variety of factors, including the size and financial needs.
On the retail side, clearly differentiates between individual lenders and small
business borrowers. In the wholesaler part, however, the differentiation tends
to be more complex.
Retail borrowers
Retail borrowers include consumers (individuals) who borrow money to buy
homes, cars and other goods. Generally, consumers with a high income, low
debt levels and consistent record of repayment of loans, borrowers are
considered lower risk, but the score of a borrower, ultimately, depends on a
variety of criteria.
In today's banking environment, retail banking has become similar to the
commodity business. Most banks currently grouped its retail borrowers in
relatively homogeneous risk groups based on standardized criteria.
This process enables banks to analyze characteristics and unpaid refund based
on standardized characteristics of borrowers. One aspect of this process is the

credit score (scoring), which lets you group and analyze the common
characteristics of loans and borrowers.
Corporate borrowers
Corporate borrowers include businesses ranging from small local businesses to
large global corporations. Each has different financial needs, and each must be
analyzed separately.
Depending on the ease of access to capital (regulated markets, banks, private
funding). Companies can borrow capital or increase its own resources to
finance growth and income. When they borrow, companies typically return their
obligations with cash generated by growth.
Local companies: These companies are commonly known as small and
medium enterprises (SMEs). SMEs are usually minor, such corporate entities as
corporations, family businesses, businesses owned and other small businesses.
SMEs are usually privately owned and have a simple structure. Annual sales are
usually below $ 1 million, EUR GBP 750,000 or 500,000, but the size of
business varies between institutions and regulatory frameworks for action
Regional Enterprises: regional commercial business companies are normally
larger SMEs and include franchises, gas stations and restaurants with sales
between USD 1 million and USD 100 million. Some fall under the definition of
SMEs according to Basel II. In addition their business normally exposed to one
or more local markets or cause them an overview within a region. The legal
structure and property of these business can be more complex, with multiple
owners, multiple subsidiaries and located in different legal jurisdictions.
International Business: international companies operate in more than one
country, but generally limit their activities to a certain geographic region.
Companies can be listed on a stock exchange, or otherwise, or may be big
business, private property that they operate in several countries. International
companies may have large annual sales (normally billion) and will need to
regularly receive credit by banks to maintain their activities and growth.
Global companies: these companies are generally considered as global
conglomerates with exhibitions worldwide. Normally manage their permanently

keeping abreast of global trade pressures and business issues. Most traded on
a stock exchange.

Sovereign borrowers
Sovereign borrowers are governments that raise capital through bonds or
directly receive credit, usually the world's largest banks. The amounts
generated are often used for large infrastructure investments (improved roads,
railway lines) or to finance public spending.
Governments use tax revenue to repay these loans. Overall rating agencies
rate the sovereign borrowers like any other debtor. The credit rating of
sovereign borrowers including their ability to manage internal and global
changes affecting the economy, politics, interest rate and commodity.
Public borrowers
Public borrowers are primarily state, provincial and local (municipal)
governments and their subordinate entities (for example, water and sewage
fees, airport authorities, public hospitals and school districts).
Amounts taken to credit these levels are typically used for investments (road
maintenance, water supply) or overhead. Since most local governments have
the ability to generate cash through taxation of taxpayers, public loans are
considered relatively low risk.
2.4.-characteristics of credit products
There is a wide variety of types of credit. All were developed to meet specific
needs arising from the unique circumstances of different borrowers. To find out
which type of credit operation is most appropriate for a borrower, lenders must
know the details of the borrower's financial situation, especially as it relates to
the present and future conditions in local, regional or international markets.
2.4.1. Maturity
The credit requirements vary between different time periods, with loans to
meet those needs usually classified by maturity. The maturity simply means

the date that has been making the last payment of the loan or other financial
product. For example, a loan with a maturity of one year should be returned for
a full year.

2.4.2.-specification of legal tender

Bank lines of credit are classified as committed or uncommitted.
The committed credit: characterized by formal credit arrangements, usually
for a year or more. With the committed lines of credit, the bank gets a margin
above its own cost of financing; to include an origination fee, a commission of
availability and a fee for the amount of credit that the bank has granted to the
borrower, regardless of whether the borrower uses the amount in full or not.
The cost of financing
Reflects the existing interest rates in the market, the cost of the bank's own
funds to ensure that pay a margin to cover the cost of processing assets.
The arrangement fee
is a fee charged by the bank to make the credit available and all aspects of the
program that allows the borrower to receive the funds as and when needed.
The availability fee
It is the commission that the lender charges the borrower for its commitment to
make available a line of credit and guarantee that a credit will be available to
the borrower at a later date, even if the loan in question is not used at that
particular time.
The uncommitted credit lines: less firmales agreements, but often include a
credit line letter stating that the funds are available upon request, but only at
the discretion of the lender.
Credit lines are not compromised in the short term in nature. Credit lines
uncommitted credit usually cheaper than the committed credit lines and priced
at a margin above the bank base rate.

2. 4. 3-destination of the credit

The use of the loan amount may vary greatly and have influence on the
lender's credit decision. A loan used to finance inventory, to purchase
equipment used in the production process or to meet some kind of need for
working capital.
2.4.4-source of payments for repayment
Another way to distinguish between different types of loans is to analyze the
way in which the borrower generates the funds to repay the loan.
Convertible loans: also known as self-liquidating loans are loans that are
returned by transforming cash assets used as security for the loan. The
convertible loan is usually considered short term.
The project finance loans: a bank provides funds that are returned to the cash
flow generated by the operations of the company.
The loan collateral: a bank gives a loan after a specific asset or combination of
assets to be held as cash collateral, or to cover the credit value. The warranty
for this type of loan normally include inventory, machinery and equipment,
leases, fixtures and fittings or other intangible assets.
2.4.5-warranty Requirements
The assets provided by a borrower to secure a loan is called collateral (or
value). A guarantee is used by the bank to safeguard their capital, and can
function as insurance in case the borrower cannot repay your credit. Then, in
case of default, the bank has the option to accept the collateral as full or partial
payment of principal, accrued interest, fees and costs and expenses of credit.

2. 4.6-covenants required

The agreements are unilateral commitments or promises the debtor to fulfill an

obligation. The essential purpose of the agreements in the financial market is
to try to prevent events and / 8 processes that could be a potential
deterioration in the financial or business condition of the borrower. Conventions
are a control mechanism and typically restrict or affect the borrower's ability to
manage its business.
2.4.7.-system Characteristics amortization
Credit products are also distinguished by the repayment system. Payments
stipulated that borrowers made to lenders throughout the lifetime of the loan from the day, the credit until the day on which it is returned fully funded include both contractual interest payments as refund of the amount taken
credit or principal.
The interest rates of the loans can be fixed or variable.
Credit fixed rate: the interest rate charged on the loan does not change during
the life of it.
Credit variable rate: the interest charged on the loan is attached to a base,
defined by an independent third party, or an index type. The bank will add a
fee to the bank base rate or index for more profit.
There are three main methods for calculating the amortization of a loan: the
sinking fund amortization, amortization of fixed fee and repayment system final
installment.
System sinking fund amortization: the borrower pays a predetermined amount
of principal and interest on the remaining outstanding balance of the loan, loan
payments initially simple amortization are great, but as the principal is
reduced, the payment of accrued interest on the remaining balance on the
remaining outstanding balance of the loan is reduced.
If the loan is a fixed rate portion of the premium that reflects interest payments
will decrease over the life of the loan, if floating rate interest payments will
vary.

Fixed repayment system to share: the borrower in each payment date, a

payment for a predetermined amount of principal and interest on the
outstanding balance of the loan. Payments at a fixed rate do not change over
time: the amount payable is the same every month, but the portion of interest
payments with respect to the repayment of principal does change.
Initially, the part of interest payments is significantly higher than returns on
capital, but over time the part corresponding to the principal repayment
increases. With a variable rate loan, the interest payments will change as does
the rate or the base rate, and the amount payable varies, requiring changes in
payments to fixed fee to cover changes in the interest rate.
System payback final installment: is that a large payment at maturity, usually
including the repayment of principal is made. A great structure amortization
balloon payment may include all accrued interest on the loan, but the borrower
typically pays interest on the outstanding credit periodically and returns the
principal in full at maturity. In the end credits of variable rate as payments are
determined by the index change over time.
3.- Banking credit risk
Bank credit risk refers to the totality of risk incurred by a bank from all of the
loans that it issues to various customers. The risk for banks in issuing loans is
that the borrowers will not repay the amount that is owed in the time that is
specified by the loan agreement. If enough customers default on their loans, a
bank can find itself in a serious financial predicament.
Many people view banks as reliable institutions that have the stability to issue
loans in a prompt manner. There is no guarantee for banks, however, that
these loans will be repaid. Since many of the loans offered by banks are
unsecured, which means that there is no collateral offered by the borrower,
banks receive little recompense when a borrower defaults on a loan. For that
reason, a bank must manage bank credit risk to protect against the severe
complications that can arise from multiple defaults.
Most banks have a specific department that specializes in the management of
bank credit risk. The individuals in charge of this department must make sure

that the bank's exposure on loans is never so significant that it would affect
operations if a worst-case scenario of multiple defaults occurs. These managers
must also be aware that loans are often very profitable for banks, which make
money from interest payments, so they must be ready to assume some degree
of acceptable risk as the price of doing business.
The best method of managing bank credit risk is to keep close tabs on the
individuals or institutions to which a bank might be compelled to lend money.
Credit ratings are one way to measure the reliability of borrowers. If a borrower
has a particularly troublesome credit rating, a bank would likely pass on
offering a loan to this individual, or it would only do so at terms that are
extremely favorable to the bank.
Another method available to banks when attempting to lessen bank credit risk
is insurance. This is a wise strategy when the bank issues a loan so large that it
would cause serious problems if the borrower does not make repayment. If
there is no way to secure such a loan with collateral, an insurance policy that
covers the bank in case of default can help to mitigate the damage done if
repayment is never made.
4.- Elements of Credit
The main elements of which depends on the credit risk of the asset are
financial and debtor. Both factors influence the values presented by
fundamental variables in measuring credit risk, being instrumental in same.
4.1 Financial Assets
Financial assets can be defined as "securities issued by economic spending
units, which are a means of maintaining wealth for those who own and a
liability to those who generate"
4.1.1 Illiquid assets
Liquidity is one of the characteristics of financial assets-along with and the riskreturn, which depends on the ease with which they can be converted into cash
easily, quickly and without significant loss of value form. Financial assets may
have varying degrees of liquidity. However,

when this feature is used as classification criteria are often distinguished two
categories, which correspond to the extreme cases can occur, which are:
1. Liquid financial assets, which are characterized by a high degree of liquidity
provided by secondary trading on financial markets characterized, in turn, to be
large, flexible and deep. These financial assets are essentially the most traded
organized secondary markets, including equity that traded on the stock
exchanges.
2 Illiquid financial assets, which are those that are characterized by either
illiquid because they are not traded on any financial market secondary, or their
liquidity is reduced, which is mainly due to
traded on secondary markets that lack the characteristics of breadth, depth
and flexibility.
The degree of liquidity of a financial asset depends on:
1 The characteristics of the financial market where trades.
The liquidity of the asset will be lower the lower the trading volume that exist
in the financial market in question. Lower trading volumes may result in a
situation cyclical, such as an economic or financial crisis; or may be the result
of a structural situation that produced the financial market lacks the breadth,
depth and flexibility needed for financial assets that are traded in the liquid.
2 The characteristics of the financial asset.
Thus, there is a direct relationship between the degree of liquidity a financial
asset, which is linked, in turn, with the financial market in emitted or negotiates
the financial asset, so that assets are issued or traded in organized financial
markets.
Assets are established by the clearing house, they are more liquid than those
not issued or traded in organized financial markets, in which establish the
characteristics of the active buyer and seller mutually agreement.
The main implications of the lack of liquidity of financial assets has for
measuring credit risk are the following three:

1. Lacks the information that financial markets provide for measurement of

credit risk, or the information is not reliable.
2. No instrument measuring financial assets that financial markets provided
through the market price, or the price does not can be used as a reliable
estimate of the asset value.
3 If there is no financial market, the sale of a financial asset can not be used as
an instrument of credit risk management

4.1.2 Assets exposed to credit risk

Financial assets exposed to it are all those assets financial in which the
financial institution has an uncertainty of objective nature of the loss which
may result in the failure of the debtor's obligations under the financial asset.
The nature of the financial asset is of great importance in measuring credit risk
because it depends on the amount of exposure to credit risk, represented by
the variable "credit exposure" and the loss experiencing financial institution in
the event of non-payment of occurring debtor, represented by the random
variable "loss given default".
For the purposes of credit risk measurement, financial assets of the economic
structure of the financial institution can be classified according to various
classification criteria among which, on one hand, belonging to the banking
book or the trading and, secondly, a proxy or not in the balance sheet of the
entity.
4.1.2.1 Loans
A loan is a financial transaction and providing simple consideration consisting,
in which the creditor is -called pawnbroker promises to deliver a certain amount
of money to the debtor -called
borrowers- and the latter undertakes to refund the amount of the agreed way
financial operation, together with interest, fees and expenses incurred in such
operation. Lenders may be of different nature, although usually it's a bank or

credit institution, in which case the loan is bank called and documented in a
contract called loan policy.
Additionally, borrowers may be private companies or households belong to the
public sector.
Loans, unless the accused, are often negotiated directly in the markets
financial side, and form part of the portfolio investment entities bank, which
usually keep them in their economic structure to its maturity and valued using
the book value.
4.1.2.2 Lines of Credit
A line of credit, or just crdito12, is an operation in which a part - originatorcalled undertakes to transfer to another property cessionary- -called economic
to a limit which can be predetermined or not, while the other part agrees to
return such goods according to the agreed conditions.
Depending on the nature of the assignor, credit lines can be classified into two
following types:
1. Commercial lines of credit, where the transferor is a company generally that
no financial grants its customers a deferment in payment of goods delivering or
services provided, giving rise to what is in the field credit company called
providers.
Although less common than supplier credit, lines of credit .They can also be
delivered to customers when a specific company amount of money on account
of purchases of goods or provision of services expect to obtain in the future,
giving rise to what in business is called customer advances. In this case the
company is the assignee and the customer is the originator.

2. Bank credit lines, in which the transferor is a bank and the transferee is any
other trader.
These lines of credit are rendering financial operations and consideration
composite in which the bank agrees to make available to its customer sums up

to a limit and for a period of time established a priori, periodically charging

interest on amounts drawn and a commission, called for availability, undrawn.
Bank credit is documented in a contract, called the credit facility, and
instrumented by a current account credit is usually unilateral and nonreciprocal type of interest, both in favor of the bank. the customer of the
financial institution can perform receipts and payments which it considers
timely, which will recorded in the current account, provided that no the default
limit is exceeded it. Like bank loans, bank lines of credit do not usually directly
traded in the secondary financial markets, and are part of the investment
portfolio of banks, which generally hold them in economic structure to maturity
and valued using the book value.

4.1.2.3 Borrowing obligations

A loan is a loan of a higher amount which is divided into a large number of
smaller loans and same features, which are amortized according to a
predetermined plan and that are offered to the general public in order to
capture the funding from both institutional investors and retail investors.
The parts where the total amount of a loan is divided are called generically
obligations, although depending on your financial economic characteristics,
fiscal and legal can receive other names such as, for eg bonds, debentures,
notes and shares.
The figure of the debtor of a debenture loan matches the issuer, which may be
a private company or public sector entity, while Creditors can be any of the
agents that are part of the system I Financial.
Borrowings obligations are generally traded in secondary markets up as the
economic structure of the financial institution are part of their trading. These
entities usually maintain the asset in its structure economy until the end of
time horizon that have preset, which can be or less maturity and valued using
the market value.

4.1.2.4 Financial assets derived

A financial derivative asset is one whose value depends on one or more
variables underlying, which may be real or financial assets. Derivative financial
assets are issued and traded in financial markets can be organized and
unorganized
From the point of view of the measurement of credit risk, as markets derivative
financial assets organized and non-organized have a number of differences.
Thus, the credit risk to which they are exposed to agents that operate in
organized financial markets is limited by a number ofmechanisms among which
are the following two:
1 Agents who sign a contract not directly related to each other if not through a
clearing house that assumes the credit risk of both parties.
However, this camera provides a series of mechanisms aimed limit the credit
risk assumed, highlighting the following:
a) The initial constitution guarantees both parties to ensure the performance of
its obligations by a deposit of money or, if the camera allows, through the
temporary assignment of financial assets.
The constitution of this warranty shall open a current account between
clearinghouse and each of the agents operating in the market.
Financial whose opening balance is equal to the amount of the security in
question.
b) The daily settlement of profits and losses, so that the positive of such
liquidation will increase the current account balance of the camera has with
each of the agents operating in the financial market and viceversa

2 The regulations governing the operation of financial markets may limit the
may experience variation from one session to another asset prices financial, in
order to limit the maximum loss that may experience the agents operating in
the financial markets or, at least, ensure that such losses gradually.

The unorganized financial markets lack these mechanisms and effective result
obtained by each party of the financial asset depends on the creditworthiness
of the other, so both are exposed to credit risk each of its counterpart.
Derivative financial assets are formalized in contracts arising rights and
obligations for both parties, and can be classified according to several criteria
among which, on the one hand, the rights and obligations provided in the
contracts and other financial markets where these are issued and traded
financial assets.
These assets are discussed in greater detail than other financial assets exposed
to credit risk because the valuation methodology of a kind-the optionsderivative financial assets used in a class of models for measuring credit risk.

4.1.2.4.1 Forwards
A forward contract is a derivative financial asset that is issued and traded in an
unorganized financial market, in which an agreement to buy or sell a real asset
or financial -called underlying asset is established, for a price -called
predetermined forward price or forward- at a future date.
The buyer of a forward contract is obligated to buy the underlying asset at the
conditions specified therein, obtaining a result that is equal to the flow.
Net cash produced by the contract delivery date, which is the difference
between the price that owns the underlying asset in the spot market on this
date and the forward price. This result is given by the following expression:

Rc t Pt F
Where:
- () C R t is the result obtained by the purchaser of the forward contract on the
date of delivery, represented by t.

- P (t) is the price of the underlying asset in the spot market on the date of
delivery.
- F is the forward price or forward. The buyer of a forward contract has a
bullish profile losses and gains can be represented by the following graph:
Figure 1.1: Profile of profit and loss of a buyer
forward contract.

The seller of a forward contract is obligated to sell the underlying asset

under the conditions specified therein, obtaining a result that is equal to the
net cash flow produced by the contract delivery date, which is the difference
between the forward price and the price that owns the underlying asset's
market of counted on this date. This result is given by the following
expression:

Rv (t) = F - P (t)
Being
() V R t the result obtained by the seller of the forward contract on the date of
delivery.
The seller of a forward contract has a bearish profile losses and gains can be
represented by the following graph:
Figure 1.2: Profile of gains and losses from the seller of a

forward contract.

The sum of the results obtained by agents that enter into a forward contract is
zero. This is because both results are symmetrical about the horizontal axis,
what in the event that the buyer of the forward for a gain, its equals the
amount of the loss experienced by the seller and vice versa, being a zero-sum
game.
4.1.2.4.2 Future Contracts
A futures contract is a derivative financial asset that is issued and traded in an
organized financial market and which is an agreement to buy or selling a real
asset or financial subyacente- -called for a fixed price - future-denominated
price at a future date (called the delivery date).
As shown, the contracts are issued and traded in markets financial
unorganized, while futures contracts are issued and traded in organized
financial markets.
4.1.2.4.3 Options Contracts
An option contract is an agreement by which one party, the buyer, acquires,
through payment of a premium, the right to buy or sell a real asset or Financial
-active subyacente-, for money at a fixed price of exercising the option- in or to

a specified time of exercise--date, while the other part, called salesman, is

awaiting the decision of the buyer.
Option contracts can be classified according to various criteria; mutually
exclusive, among which are the following two:
1 The rights acquired by the purchaser of the option, which allows to
distinguish between:
a) Options to purchase -call inglesa- language, which are those in which the
option buyer has the right to buy the underlying asset at the conditions
specified in the contract.
b) Put options -put language, which are those in which the option buyer has the
right to sell the underlying asset at the conditions specified in the contract.
2 The moment when the buyer can exercise their rights, which allows
distinguishing, in turn, between:
a) European options, which are those in which the buyer can only exercise its
right on the date of delivery.
b) American options, which are those in which the buyer can exercise their
right at any time after the purchase of the option to date delivery. In the case
of a call option, the buyer purchases by paying a premium, the right to buy the
underlying asset at the conditions specified in the option contract.
The net cash flow that gets the buyer depends on the value of the asset
underlying cash market on the date of exercise, may be the two following
situations:
1 The value of the underlying asset is greater than the exercise price of the
option, which case the buyer has the right to buy the underlying asset at price
established in the option, he will benefit from the exercise thereof and will run,
obtaining a net cash flow equal to the difference between the value of
underlying asset and the exercise price of the option.
2 The underlying asset value is equal to or less than the exercise price of the
option, in which case the buyer has the right but not the obligation to will buy

the underlying at the price established in the option asset will be impaired by
the exercise thereof and not run, obtaining a net cash flow equal zero.
Regardless of what the value of the underlying asset, the expression that
allows obtain the net cash flow that gets the buyer of a call option is:
FNCC (t) = max [P (t) - PE, 0]
Where:
- FNCC (t) is the net cash flow that the buyer of the option on the date gets
exercise.
- PE is the exercise price of the option.
Also, the buyer must pay the premium option to issue, so the result you get is
the difference between net cash flow and premium:
Rc (t) = FNCC (t) - pc
being Rc (t) the result that the buyer gets the option on the date of exercise
and c p the premium option.
The buyer of a call option has a bullish profile losses and gains with stop loss.
As for the seller of a call option, he is obliged by charging
a premium to sell, at the request of the buyer, the underlying asset under the
conditions
specified in the option contract. The net cash flow that the seller gets is the
opposite of the buyer and is given by the following expression:

FNC (t) = min [0, PE - P (t)]

Since:
FNC t the cash flow that the seller of the option at the date gets exercise. Also,
the seller receives a premium from the issuance of the purchase option
compensation for the amount of net cash flow, if any shall disbursed.
Therefore, the result obtained by the seller is the sum of the net cash box and
premium:

R( t) =FNC( t) + pc
Where:
R( t) is the result obtained by the seller of the option at the date of exercise
thereof.
The seller of a call option has a profile of bassist profit and loss limiting gains.
As regards the buyer of a put option acquires, by paying a premium, the right
to sell the underlying asset at the conditions specified in the option contract.
The net cash flow that gets the buyer depends on the value of the asset
underlying cash market on the date of exercise, being able to both following
situations:
The value of the underlying asset is less than the exercise price of the option,
which case the buyer has the right to sell the underlying asset price
established in the option, will benefit from the exercise of the same and will
run, obtaining a net cash flow equal to the difference between the price of
exercise of the option and the underlying asset price.
The underlying asset value is equal to or greater than the exercise price of the
option, in which case the buyer has the right but not the obligation to will sell
the underlying at the price established in the option asset will be impaired by
the exercise thereof and not run, obtaining a net cash flow equal zero.
A comparison on the buyer and seller is as follow:

Profit and loss profile of the buyer and seller of an option:

4.1.2.4.4 Swaps
A swap contract is a derivative financial asset that is issued and not traded in
organized financial markets, in which two parties enter into an agreement to
exchange one set of net cash flows in the future, establishing at the time of
conclusion of the contract dates which will take place the exchange of such net
cash flows and the method used to determine the amount thereof.
These contracts can be considered as a succession in time contracts term, as a
forward contract produces a unique cash flow due in one only future time, while

a swap agreement produces one or more cash flows due in one or more future
time.
The swaps may have as a type of underlying asset exchange, interest rate or
credit risk associated with other financial asset. All derivative financial assets
that have been discussed above are part of the trading of financial institutions,
which the value using market value.
4.2 Debtors
The nature of the debtor is of great importance in measuring credit risk
because it depends on the fundamentals of risk measurement credit.
This nature influences the definition of the random variable "state in which is
the debtor "in the methods and models, whether empirical or theoretical, that
may be used in determining probability distribution in the explanatory variables
that can be used in these models and in the sample or population that can be
used in the determination of its parameters.
Furthermore, the nature of the debtor also influences the random variable "loss
event of default ", since it depends on the ability of the financial institution
require the debtor to fulfill its obligations in the event of default, this
safeguarding their interests.
In this sense, the lender can go to court in order to ask a bankruptcy where the
debtor is a private company or family, which does not occur when it is a public
entity.
One of the most important criteria is the size, in terms of which distinguishes
between large, medium and small businesses. However, in many cases the
classifications are obtained using the classification criteria are imprecise, which
is mainly due to the use of different variables and units.
As in the definition of the criteria results in that they are heterogeneous, on
especially when companies market goods and services in several countries and
are classified according to the criteria usually used in them.

Considering these difficulties, the classification criteria used in this work is

established by the Committee on Banking Supervision Basilea21 that used
based on the following three criteria elements:
1 The size of the firm, measured by the annual amount of sales.
2 Exposure of the bank to credit risk of the company.
3 The method used by the financial institution in measuring the credit risk of
the company.
Based on the criteria given above, the agency provides the following
classification of companies:
1 Large firms, which are those with annual sales is equal to or than fifty million
euros.
2 Small and medium enterprises, which are those with annual sales is less than
fifty million euros.
This body distinction, in turn, between two types of small and medium
companies: one composed of companies with an annual sales amount less than
fifty million euros, and those formed by other companies in which, in addition,
the financial institution has a credit risk exposure less than one million euros
and employs a methodology for measuring this risk similar to that used in
families.
This classification is important because of the differences that have large and
SMEs in the measurement of credit risk
5.-Credit scoring
5.1 Scoring: It is a point system for admission or concession operations for
deciding who extend credit, how much credit to grant. Is based on an algorithm
that provides a score indicative of the credit quality of the transaction.
The system sets a higher threshold for middle and lower determine if passed
directly to test you or
reject it. Are used for very standardized operations retail segment (consumer
credit, mortgages, and others.)

It reduces the cost of analysis credit.

Shortens the concession in credit operation
Provides assessments homogeneous credit quality
Enables implementation of concession strategies differentiated
Detects quickly changes in the credit quality accredited.
Types of Scoring
a) Scoring reagents: determines the possible grant from information not related
to the behavior of client.
b) Scoring of behavior: It takes into account variables Operation own customer
and available
earlier (late payment, arrears) and behavior Customer (maintained balance,
movement, residence,
enforcing quotas). It is used to check the limits and monitoring risk.
c) Proactive Scoring: analyzes of the same variables behavioral scoring but in
order to offer new products to customers.
5.2 Rating : It is a system that allows the classification of customers risks
homogeneous classes.
Used in evaluating businesses (SMEs, companies, corporations)
The evaluation is accurate and objective, usually refers to the probability of
default (PD)
It reflects the ability and willingness of the customer based on relevant and
updated borrower information.
It is sensitive to changes in the credit quality of debtor
Allows a better perception of the overall quality of the portfolio, being
segmented into risk categories.
The development of a rating system lies in the estimation of probability of
default (PD)

category associated with your credit.

The criteria are:

The system of internal rate be applied to each risk portfolio.

The database must be representative for the development probability of

default.
Each financial institution will have sufficient understanding of the
system
internal rating and capacity monitoring.

6. - Enterprise credit risk

6.1. Significant features at risk measeurement credit for large
companies
The main features of the large companies that are relevant to the
measurement of credit risk are:
1. The portfolios of receivables are financial assets with large companies
characterized by being composed of a small number of financial assets grants,
which, compared with other portfolios of financial assets as, for example, are
those composed of loans to small and medium companies, has the following
differences:
a) The performance by the bank receives such assets financiers is higher,
which is due to the costs of testing and measuring the credit risk are primarily
fixed, while the income provide financial assets exposed to credit risk are
variable, depending mainly on the amount thereof.
b) The variables "exposure to credit risk" and "risk of loss associated Credit
"may present high values, so that, in the worst case cases, the default of the
debtor may adversely affect the solvency of the financial institution.
c) The diversification benefits of financial risks posed to entity in such portfolios
are large, so that the concentration a very high cost to the state.
2. From the point of view of the information available to the financial institution,
the

Large companies are characterized by being more transparent, which is due to

the two
following reasons:
a) Both financial institutions and other actors in financial markets as, for
example, credit rating agencies, have been collected information about the
credit risk of large enterprises for a extended period, so that the information
which exists for the measurement of this risk is sufficient, including one or
more complete business cycles.
b) Large firms are characterized by the ease with which to access financial
markets, which provide a source of information important for measuring credit
risk.
In this regard, the primary and organized financial markets provide information
to the financial institution through which emit rankings credit rating agencies
and the financial information
the company must submit to the supervisory and control they authorize the
issuance of financial assets.
Meanwhile, the secondary and organized financial markets provide information
through the prices of financial assets issued by the business and financial
information that it must provide bodies of supervision and control in order that
they do not
revoke your authorization negotiation of such assets.
3. In measuring credit risk of large companies, entities ascendentes22 often
use financial systems as well as methods and models mercado adjusted.
4. Key variables in measuring credit risk of large companies have some core
values that are different from other debtors.
Thus, the probability that the random variable "state that is the debtor "present
the default value in large enterprises is lower than in the small and medium
enterprises. In contrast, the dependence between variables random two large
companies "state in which the debtor is"

is greater than any two SMEs.

The majority of financial assets issued by large companies are characterized
that are traded directly on secondary financial markets, which is in itself an
instrument of credit risk assessment and provide tools for managing this risk.
6.2 Significant features at risk measurement credit for small and
medium
The main characteristics of SMEs that are relevant for measuring credit risk
are as follows:
1. Holdings of financial assets whose debtors are small and medium companies
are characterized by being composed of many financial assets reduced
amount, which, compared with other portfolios of financial assets as, for
example, consist of loans to large companies, involves
following differences:
a) The performance by the bank receives such assets
Financial is smaller due to the reasons that have been discussed more up to
large companies.
b) The values presented variables "credit exposure" and "Credit risk associated
with loss" is reduced, and therefore, the default of a debtor does not affect the
solvency of the bank.
c) Such portfolios are greatly benefiting from diversification.
2. From the point of view of the information available to the bank, the SMEs are
characterized by opaque, which is due to following three reasons:
a) The banks have recently started collecting information on the credit risk of
small and medium enterprises. Likewise, given the fact that such entities are
the only ones who have access this type of information, which is one of its
competitive advantages.
However, this information does not cover one or more business cycles
complete, so it is still not enough.

b) The requirements of accounting information and corporate law requires a

large firms are more stringent than those required for small and medium
enterprises, so that the quantity and quality of information economic and
financial that banks have the latter type companies is lower.
c) Small and medium enterprises are characterized by the difficulty
to access the capital markets, which provide abundant information on
companies.
3. In measuring credit risk of small and medium enterprises, descendentes24
financial institutions typically employ systems and methods.
4. Key variables in measuring credit risk have a eigenvalues in small and
medium enterprises.
As discussed above, the probability that the random variable "state in which
the debtor is "present the default value in small and medium enterprises is
higher than in large firms, while the
dependence between random variables "state in which the debtor is" two SMEs
is lower than any two firms big.
5. The majority of financial assets exposed to credit risk and issued by Small
and medium enterprises are characterized not traded directly in secondary
financial markets, making it difficult to measure, management and assessment
of credit risk of these financial assets.
This is the case for most of the financial assets comprising the portfolio of
investment of the bank, such as, for example, loans and lines of credit to small
and medium enterprises
7. - 5 C of credit
The main factors to be taken into account in deciding whether to grant a loan
or are named as the five Cs of credit and are as follows:
Capacity: The ability to pay of the borrower is the most important factor in the
decision of the bank. Is to assess the ability and experience in business having
the person or company, its management and practical results. For this

valuation takes into account seniority, growth, channels of distribution, money,

number of employees, etc.
Capital: This refers to the amounts invested in the business of the borrower,
as well as obligations, ie, a study of finance. For the assessment analyzing your
financial situation is required. A detailed financial analysis can fully understand
the possibilities of payment, the flow of income and expenditure as well as the
ability to borrow. The cash flow, inventory rotation, the average time it takes to
pay, etc.
Collateral: All those elements available to the borrower to ensure compliance
with the payment on credit, ie, the guarantees or collateral support. It is
assessed through its fixed assets, the economic value and quality of these, as
in the analysis of credit provides that a loan will not be granted without having
provided a second source of payment
Character: These are the qualities of good repute and moral character that
has the debtor to respond to credit. Information about your payment habits and
behavior in lending operations past and present, in relation to payments is
sought. The valuation of character or moral worthiness of a customer must be
made from robust, quantifiable and verifiable elements such as:

Commercial references from other suppliers with whom you have credit

The verification of lawsuits

Bank references

Conditions: These are the external factors that can affect the performance of
the business of the borrower, such as economic conditions and industry or the
political and economic situation in the region. Although these factors are not

under the control of borrower, are considered in the analysis of credit to

anticipate their possible effects.
8.-Conclusions
Credit risk has a very important place for companies and institutions financial.
Among the reasons for the growing importance of risk credit. A highlight for
financial institutions and their regulators issue is the adequacy of capital
required to cover credit risk (on and off balance sheet) as recommended by the
Basel Committee, through Basel 2
By this, we seek to propose regulating levels of requirements minimum capital
of financial institutions so that they are consistent with the sophistication of
banking and financial markets in the last decade. The objective of this proposal
is to encourage improvement in the quality and
internal control systems and risk management entities.
It is noteworthy that risk management is not inexpensive, in fact, is an activity
that requires resources, however, it is necessary to note that the cost of
delaying or preventing a proper assessment of the risks assumed can be
extreme, eventually leading to the collapse of an institution and possibly cause
problems throughout a banking system.

Furthermore, it is important to note that when financial institutions operate on

the basis of risk-adjusted returns, risk management contributes to
strengthening and efficiency of the economic system, as it provides a
mechanism that is designed to channel financial resources to the Ultimately, it
is your actual use resources more efficiently. Projects with expected returns,
adjusted for risk, the higher will be the most likely to obtain the requested
funding, but also be the ones most likely to succeed. The result is greater
economic growth, following a proper risk management from the financial sector

9. Bibliographic references

-APOSTOLINK & DONOHUE & WENT. Fundamentos del riesgo bancario y

regulacin. Captulo 5.
-JEFF MADURA, Mercados e Instituciones Financieras. Octava Edicion (2010)
Editorial Cengage Learning
-DAVID AMBROSINI VALDEZ. Introduccion a la Banca. Segunda Edicion (2002).
Editorial Centro de Investigacion de la Universidad del Pacifico.
- ROSS- WESTERFIELD JAFFE (2009) Finanzas Coporativas. Octava Edicion.
Mexico: Editorial Mc Graw Hill.
- TERRY BENZCHAWEL. Credit Risk Modelling-Facts, Theory and Applications
(2012)
-Bluhm, Christian, Ludger Overbeck, and Christoph Wagner (2002) An
Introduction to Credit Risk Modeling.
- Arnaud and Olivier Renault (2004) The Standard Poors Guide to Measuring
and Manging Credit Risk.
- Darrell Duffle and Keneth J. Singleton (200) Credit Risk: Pricing, Measurement.
Princeton universitu Press
- Principles for the management of credit risk fron the Bank for International
Settlements.