Credit equivalents

Today creditors behave according to the risk compensation hypothesis: According to this, lenders take on the risk of default, they can be compensated for a risk premium by charging a higher total interest rate for the borrowed capital (compared to the yield on bonds, the creditworthiness of which is beyond question). In other words, the creditor gives the loan for which he charges the market interest rate and, just like an insurance company, assumes the risk of the debtor's possible default. The credit risk premium must be paid for this. Empirical evidence shows that this credit risk premium is even slightly higher than the mean default costs.
When assessing the creditworthiness, the probability of a default is estimated. However, the default rates do not say anything about whether "everything is lost" in the event of a default, or whether the debtor may still be able to settle part of the claim in the subsequent period. For this reason, an actuarial (actuarial) approach is chosen when measuring the default costs to be expected on a loan.

All counterparty risks, including those in connection with derivatives, are presented as the expected default of an equivalent loan. This approach is known as the credit equivalent.

With this approach, three questions are asked for each position with a counterparty risk (counterparty could default):

1. Nominal amount N: If there were to be a default, what is the nominal amount of the affected position and how does this nominal amount change in the course of the contractual relationship. For example, it takes into account whether a loan is being repaid. In the case of a loan with scheduled repayment, if a default occurs after a few years, the nominal amount affected is slightly lower than if this loan had no scheduled repayment.

2. Default rate D: What is the probability of failure and what assumptions can be made about the change in failure rates over time? This is where the country risk, the creditworthiness of the counterparty and collateral in the broader sense (covenants) play a role.

3. Recovery rate R: If there were a default, what would be the percentage of the nominal amount of the affected position that can be expected to be recovered. This size is largely determined by rank and securities.
The risk premium to be demanded in the loan agreement as an absolute amount is based on the product:

Credit risk premium = proportional to N * D * (1 - R)

Especially if the credit risk premium cannot be set anew every year, it must be taken into account when the contract is signed how these three parameters will change over time. These calculations make up the credit equivalent approach.

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