136 Credit Risk Review ARFE 2009

136 Credit Risk Review ARFE 2009 - Review in Advance first...

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Credit Risk Models Robert A. Jarrow Johnson Graduate School of Management, Cornell University, Ithaca, New York 14853; email: raj15@cornell.edu Annu. Rev. Financ. Econ. 2009. 9:1–32 First published online as a Review in Advance on April 21, 2009 The Annual Review of Financ. Econ. is online at financial.annualreviews.org This article’s doi: 10.1146/annurev . financial . 050808 . 114300 Copyright © 2009 by Annual Reviews. All rights reserved 1941-1367/09/1205-0000$20.00 Key Words structural models, reduced form models, credit derivatives, default contagion, credit default swaps Abstract This paper reviews the literature on credit risk models. Topics included are structural and reduced form models, incomplete infor- mation, credit derivatives, and default contagion. It is argued that reduced form models and not structural models are appropriate for the pricing and hedging of credit-risky securities. Directions for future research are discussed. 9.1 Review in Advance first posted online on September 16 , 200 9 . (Minor changes may still occur before final publication online and in print.) Annu. Rev. Fin. Econ. 2009.1. Downloaded from arjournals.annualreviews.org by Robert A. Jarrow on 10/20/09. For personal use only.
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1. INTRODUCTION From a historical perspective, credit risk is the final frontier of option pricing theory. Valuing credit-risky securities necessitates an understanding of standard option pricing theory, but under a stochastic term structure of interest rates. Standard option pricing theory came first with the development of the Black-Scholes-Merton model (Black & Scholes 1973, Merton 1973), followed over a decade later by the term structure of interest rates option pricing technology of Heath et al. (1992). Extending the Heath-Jarrow- Morton (HJM) model to include default—credit risk—yields a fresh and currently active research area within financial economics. Credit risk arises whenever two counterparties engage in borrowing and lending. Borrowing can be in cash, which is the standard case, or it can be through the “shorting” of securities. Shorting a security is selling a security one does not own. To do this, the security must first be borrowed from an intermediate counterparty, with an obligation to return the borrowed security at a later date. The borrowing part of this shorting transac- tion involves credit risk. Because the majority of transactions in financial and commodity markets involve some sort of borrowing, understanding the economics of credit risk is fundamental to the broader understanding of economics itself. 1 Another reason for studying credit risk is the recent expansion in the trading of credit derivatives. Trading in credit derivatives began in the early 1990s. Credit derivatives are financial contracts whose payoffs depend on whether some credit entity (e.g., a person, corporation, bank, government, or trust 2 ) defaults on its debt. Traded are many different varieties of credit default swaps (CDS), credit derivatives on baskets, and collateralized default obligations (CDO). In 2007, the International Swaps and Derivatives Association estimated the outstanding notional in credit derivatives to be over 62 trillion dollars.
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136 Credit Risk Review ARFE 2009 - Review in Advance first...

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