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Fixed IncomeModule 5 of 5

Credit Risk and Credit Analysis

5

Concepts

3

Formulas

1

Decisions

3

Quiz Questions

Key Concepts

5 concepts covered in this module.

Credit Risk Components

Default risk (probability of default), Loss severity (loss given default), Recovery rate (1 - loss severity). Expected loss = PD × LGD.

Credit Spread

Yield premium over risk-free rate for credit risk. Wider spread = higher perceived risk. Spreads widen in economic downturns.

Credit Ratings

Investment grade: AAA to BBB-. High yield (junk): BB+ and below. Ratings assess default probability, not loss severity.

Credit Migration

Rating upgrade: spread tightens, price rises. Rating downgrade: spread widens, price falls. "Fallen angel": IG to HY.

4 Cs of Credit Analysis

Capacity (ability to pay), Collateral (asset backing), Covenants (legal protections), Character (management quality).

Formulas

3 essential formulas for this module.

Expected Loss

EL = PD × LGD × EAD

Where: PD = probability of default, LGD = loss given default, EAD = exposure at default

Loss Given Default

LGD = 1 - Recovery Rate

Where: Percentage of exposure lost

Credit Spread

Credit Spread = YTMcorporate - YTMrisk-free

Where: Compensation for credit risk

Decision Frameworks

1 decision frameworks to guide your analysis.

Investment grade vs High yield?

  • IG: lower default risk, lower yield, suitable for conservative portfolios
  • HY: higher yield for accepting more default risk, less sensitive to rate changes, more to credit cycle

Mind Map

Visual overview of how concepts connect in this module.

Credit Risk
Risk Components
Default probability
Loss given default
Recovery rate
Expected loss
Credit Spread
Yield over risk-free
Widens in recession
Tightens in expansion
Spread duration
Ratings
AAA to BBB- = IG
BB+ and below = HY
Rating agencies
Migration risk
4 Cs
Capacity
Collateral
Covenants
Character
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Credit Risk Components

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Answer
Default risk (probability of default), Loss severity (loss given default), Recovery rate (1 - loss severity). Expected loss = PD × LGD.
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