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20PricingBasicsBanksandfinancialinstitutionsareinthebusinessofunderwritingrisks.Inordertosurviveasaviableenterprise,itisnotonlyessentialtohaveappropriateriskidentificationandmitigationstrateg
2、ies,butanadequateriskpricingmechanismisalsovital.Afinancialinstitutionengagedinmultiplelinesofriskunderwritingmustensurethateveryriskispricedadequately,basedonthetypeofrisksunderwritten.Appropriateriskpricingiskeytothesuccessofallriskunderwritingbusinessirrespectiveofwhetheritiscreditrisk,deriv
3、ativerisk,insuranceriskorequityrisk.Creditriskpricingcanoftenbechallenging.Moderndaycreditproductsarebecomingcomplex,hencethepricingofvarioustypesofstructuredproductssuchasCDO,creditderivativesandcreditriskinsuranceproductsrequiresin-depthunderstandingandanalysis.Forexample,AIG,thelargestUSinsu
4、rancecompanyearnedjust15%oftotalrevenuefromitsFinancialProductsDivisionduring2008.ThisdivisionprimarilyofferedCDS,i.e.creditinsuranceandcollectedpremiums.CDSisacomplexproductwherebothcreditandinsurancerisksareinvolvedand,ifnotpricedproperly,couldhavedisastrousconsequences.AIGhadinappropriatelyp
5、ricedinthecreditriskelementinCDS,whichultimatelyledAIGtothebrinkofbankruptcyduring2008.AswehaveseeninChapter1,abank/FIenjoyinganinterestmargin(netspread)of2%,ifitsuffersacreditlossof$1m,willhavetodeploy$50m($1m/2%)torecouptheloss.Inotherwords,50timesthemoneylost(creditloss)needstobedeployedtore
6、couptheloss.Hence,suppliersofcreditoughttoverycarefulwhileidentifyingandpricingacreditasset.20.1CREDITPRICINGFACTORSWhilepricingcreditrisk,severalfactorsneedtobeconsidered.Thecreditdefaultriskismostcritical.However,therearealsootherfactorstobeconsidered,forexample,costoffunds.Figure20.1showsthe
7、majorfactorstobeconsideredwhilepricingacreditasset.Itmaybenotedthatthediagramisonlyindicativeandadditionalfactors–forexampleliquidityormigrationrisk–mayalsoneedtobeconsidereddependinguponthecircumstances.Letusexamineeachfactorinde
