Fundamentals of Financial Risk Management Chapter 5 Credit Risk Theory Author: Clifford V. Rossi John Wiley and Sons 1
Fundamentals of Financial Risk Management Overview of Credit Risk Theory Borrowers can be individuals, corporations or even governments seeking credit. And while the drivers of default for each may differ, the underlying theory of default remains the same. In this chapter a theory of default first introduced by Robert Merton presents the foundation efforts to measure and manage credit risk exposure. It views default as an embedded put option available to the borrower when circumstances are economically attractive for the borrower to “exercise” their option to default. 2
Fundamentals of Financial Risk Management Overview of Credit Risk Theory This option-theoretic framework can be characterized for any type of borrower and used as the basis for empirical default modeling. Credit loss estimates are formed on the basis of combining the borrower’s probability of default (or default frequency) with their loss given default (LGD), or loss severity. The Merton default model provides a way to conceptually determine both loss components. 3
Fundamentals of Financial Risk Management Overview of Credit Risk Theory With a basic theory of credit risk established, the remainder of the chapter examines three important approaches to measuring credit risk. Leveraging the Merton model, the first introduces the concept of credit spreads, or the additional amount of yield needed on a financial instrument subject to default over a comparable duration risk-free instrument. Credit spreads provide analysts with an important way to extract an estimate of default embedded within the financial contract by observing market prices of underlying assets. 4
Fundamentals of Financial Risk Management Overview of Credit Risk Theory The second area of focus is with regard to credit portfolio management. Over the years a number of techniques have emerged that allow credit managers to look at tradeoffs among different types of assets from a credit perspective, drawing on theory first applied to investment management. In addition, key concepts around credit migration, reflecting the dynamics that credit risk is not static over time are reviewed and applied to a simple SifiBank credit portfolio. 5
Fundamentals of Financial Risk Management Overview of Credit Risk Theory Finally, putting all these pieces together, an example of how a loss distribution can be generated through Monte Carlo simulation provides the basis for determining actuarial fair pricing of credit losses on a portfolio. Such techniques are critical for institutions looking to determine fair value for credit risk in their portfolio, providing guarantees on loans or for trading credit risk in financial markets.
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