Credit Risk and Credit Derivatives
Businesses try to account for credit risk, if a company goes bankrupt. With the recent
bankruptcies of several airlines, Delphi car parts, and the talk of whether GM or Ford will
follow, this has been particularly important at many banks.
Many institutions hold portfolios of corporate bonds which are clearly liable to bankruptcy by
the corporation that issued them. However there is also counterparty risk: my supplier or buyer
(or competitor!) could go out of business.
Credit Rating Agencies such as Moody’s, S&P, and Fitch, try to rate corporate bonds. Moody’s
uses Aaa, Aa, A, Baa, Ba, B, and Caa. S&P uses AAA, AA, A, BBB, BB, B, and CCC. Both
then add pluses or minuses (or numerals). Fitch is getting larger and trying to compete with the
big two. In other industries there are smaller rating agencies; for instance A.M. Best in
Moody’s ratings at or better than Baa and S&P at or better than BBB are considered “investment
grade.” This cutoff might seem arbitrary, but many regulated institutions (banks, insurers,
pension funds, etc) are required to hold only investment grade assets. Since these industries are
protected by insurance against failing, they are prevented from taking on a level of risk that is
Why do some bonds (corporate or international) pay a higher interest rate than “risk-free” US
Treasuries? Presumably this compensates for the risk involved. (Liquidity is also important but
for now we skip that.) We can split the risk into two parts: the probability of default (the
company going bankrupt) and the recovery rate (how much is lost when it goes bankrupt).