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KIC000062 - a default ~definition of default is key US Jaws...

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Credit Risk Modeling FIN 428 Prof. Hood Credit Risk Modeling - Intra Credit Risk Modeling involves the parameters of a model that outputs a probability of default for a particular issuer . Why do we care about this? - Can use for pricing existing bonds or loans - Can use to manage risk of a portfolio - Banks can use as a decision criteria for lending and for deciding on the appropriate floating rate charge. Credit Ratings vs. Credit Risk Models A long-term credit rating is a prediction of the likelihood that an issuer Dr issue will default and the severity of the loss. Ratings are supposed to be "through the cycle" estimates of credit risk, not "point in time" estimates. There are three reasons why one cannot simply rely on credit ratings as a forecaster of default: 1. Unlike defclutt prnbebilttles, credit I<Itjng~ are discrete with a limited number of I<Iting grades. 2. WhHe ratit1gs are updated very infrequently, default prob<lbilitl"s can b.e estimated on a real-time basis. 3. Thera is no clear maturity for a credit I1Iting . 1
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Difficulties in Modeling 1) What constitutes
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Unformatted text preview: a default? ~definition of default is key- US Jaws are much different from others- What we really care about i510051ng money 2) Defaults are rare events and getting the probability of default correct requires complete data 3) Deciding what sources of information to use is difficult. 4) How to estimate the term structure of default risk can be difficult. Types of Models The types of models that can be applied depends on what you are trying to accomplish 1) Fundamental Models 2) Models using market prices- Structural Models-Rl:c~;c:;el~ Q fis~ I'\i)0.YOv\ \=1) Actual vs. Risk-Neutral Probabilities Rlsk-Neutra! probability of default is NOT the actual probability of default and includes a risk premium. If you develop a term structure of risk-neutral default probabilities for a particUlar issuer, you should be able to price any security. What are you implicitly assuming? What are some problems with this? • • • 2...
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