“Cash flow is at the center of a convergence between financial valuation models and risk models that could dramatically alter the credit risk modeling landscape.
Credit risk measurement will soon undergo a sea-change as a result of the growing importance of cash flow analysis, which has been buoyed by new valuation rules.
The traditional credit risk model that has served many FRM practitioners well during the past decade is the PD/LGD/EAD model. Basically, the riskiness of a loan is expressed in three parameters: the probability that the client will default on his obligations (the probability of default, or PD); the financial loss that is incurred in case of a default as a percentage of the exposure (the loss given default, or LGD); and the exposure at default (EAD) – i.e., the remaining principal of the loan, including missed interest payments.”
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