Credit Pricing

From Open Risk Manual

Definition

Credit Pricing is the method by which a lender (or a counterparty that assumes the Credit Risk) in a new contract sets terms such as fees or the Margin on top of a reference rate that is required as compensation for the assumed credit risk. This approach is usually termed Risk Based Pricing (non-risk based pricing policies have also been used historically)

Credit pricing may be part of the overall pricing method that may involve other costs and risk elements (funding costs, pre-payment risk, other operational costs). A profit margin (or discount) will connect the ex-ante calculated components with the actual agreed pricing.

Methodology

In typical modern usage pricing methodologies decompose the task into distinct risk and cost components that are (for simplicity) assumed independent.

In turn, the specifically credit linked pricing component can be conceptually split into the main contributing risk factors:

In the context of holding a credit risky contract as part of a portfolio that must be funded in part by Risk Capital the above calculation would be referred to as an Expected Credit Loss calculation. In addition, using techniques from Economic Capital management (such as the incremental capital required to support the transaction)


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