Credit curve and CVA

[Arka Bose]

I was reading Gregory and there he mentions that 'in upward sloping curve, defaults are back loaded and in case of downward sloping curve, defaults are front loaded. What does this mean?

 

[Mkaim]

I was reading Gregory and there he mentions that 'in upward sloping curve, defaults are back loaded and in case of downward sloping curve, defaults are front loaded. What does this mean?

@arkabose - Upward sloping, which I think is the normal state, probability of default increases as time passes as a counterparty is eventually expected to default. In a downward sloping curve, which I think is a scenario where a firm may be facing hardship currently, if the firm survives the first few periods then it's expected to survive in the long run (probability of default reduces as time passes given the firm has survived the troublesome years). For downward sloping credit curve, imagine a firm that's facing financial hardship for whatever reasons right now, if it can survive via capital infusion or restructuring, then it's probability of default next year is lower than this year given it survives this year and so on for the subsequent years. Hope this helps.

Back Loaded - higher likelihood of default in later years (periods).
Front Loaded - Higher likelihood of default in the early years (periods).

Edit : Replaced "Lower" with "Higher" in the original " Lower likelihood of default in the early years (periods)." Originally a typo on my end.

 

[Arka Bose]

Yes, that is true but then why is the text showing cva increase in case of a downward sloping curve? The cva formula is LGD*EE*PD and if the credit profile is expected to improve, then shouldnt the cva be lower incasse of a downward sloping credit curve?

 

[Mkaim]

Yes, that is true but then why is the text showing cva increase in case of a downward sloping curve? The cva formula is LGD*EE*PD and if the credit profile is expected to improve, then shouldnt the cva be lower incasse of a downward sloping credit curve?

Well I think of it from a TVM (time value of money) perspective. Holding all constant, where will you experience more discounted losses, when they're expected occur next year (front loaded -->downward sloping) or when they're expected in 8 years (back loaded -->upward sloping). Example: A total loss of $10 next year discounted for 1 year will be greater than a total loss of $10 discounted for 10 years. This is how I view it.

 

[Arka Bose]

Thank you very much, makes sense.

 

[Mkaim]

Thank you very much, makes sense.

Glad I could help. It's possible David will provide more info. later as well.

 

[Taunk]

hi,

@arkabose - Upward sloping, which I think is the normal state, probability of default increases as time passes as a counterparty is eventually expected to default. In a downward sloping curve, which I think is a scenario where a firm may be facing hardship currently, if the firm survives the first few periods then it's expected to survive in the long run (probability of default reduces as time passes given the firm has survived the troublesome years). For downward sloping credit curve, imagine a firm that's facing financial hardship for whatever reasons right now, if it can survive via capital infusion or restructuring, then it's probability of default next year is lower than this year given it survives this year and so on for the subsequent years. Hope this helps.

Back Loaded - higher likelihood of default in later years (periods).
Front Loaded - Lower likelihood of default in the early years (periods).

Hi mkaim,
i reckon front loaded will mean higher likelihood of default in the earlier years.

 

[Mkaim]

Hi @taunk ,

Yes, typo on my end. You're right. Explanation became a little too wordy so I missed my own typo . Thanks for correcting!