Credit Risk: Pricing, Measurement, and Management

Article excerpt

Credit Risk: Pricing, Measurement, and Management, by Darrell Duffie and Kenneth J. Singleton, 2003, Princeton, NJ: Princeton University Press

Credit risk is the major challenge for risk managers and market regulators. International regulation of banks' credit risk was put in place in 1988 and since that time there has been no consensus on how to improve that regulatory framework. Part of the explanation resides in the complexity of this risk. Banks, regulators, and central banks do not agree on how to measure credit risk and, more particularly, on how to compute the optimal capital that is necessary for protecting the different partners that share this risk. For example, what proportion of yield spreads on corporate bonds is explained by credit risk? Is it 30 percent, 50 percent, or even 90 percent? Is the credit risk proportion of the observed spreads solely a function of variations in the default probability or is it also explained by variations in the recovery rate over time or across cycles? Are macroeconomic cycles themselves or default risk premia, market liquidity, and even market risk significant determinants of yield spreads? These questions are important because some models such as CreditMetrics use the entire yield spread to compute the capital for credit risk. If credit risk explains only a small fraction of yield spreads, these models compute too much capital for regulation and even for credit risk management (Dionne et al., 2004 and references therein).

Asking banks to keep too much capital in reserve to cover credit risk can be a source of market distortion in risk management behavior (Allen and Gale, 2003; Dionne and Harchaoui, 2003). For example, it may generate some asset substitution activities that increase the risky position of banks, in order to set the level of risk at its optimal rather than regulatory level. All these issues arise in part because credit risk is not well understood. So the book by Duffie and Singleton will be welcomed by the academics, regulators, and practitioners who consult it.

The book has 13 chapters, three appendices (two on affine processes), a comprehensive list of references, and an index (authors and subjects). It covers all subjects related to credit risk. It is designed for three broad audiences: academics and graduate students; those involved in the measurement and control of financial risks; and those involved in trading and marketing products with significant credit risk. The main focus is modeling credit risk: measuring portfolio credit risk and pricing different securities exposed to credit risk. The focus on credit risk management is less important in the book.

The introduction (indeed the entire book) is very well written and presents the subjects treated with clarity. Credit risk is distinguished from other sources of risk such as market risk, liquidity risk, operational risk, systemic risk, and regulatory and legal risk. The distinctions take many dimensions such as time horizon, liquidity, the parties implicated, methodology, and information asymmetries. However, the authors insist on the fact that this does not mean that all these different risks should be managed separately. These different risks may be correlated over time, so integrated frameworks for measuring and pricing them are necessary, particularly for market, credit, and liquidity risks. For example, factors underlying changes in credit risk are often correlated with those underlying market risk and changes in liquidity risk can be viewed as a component of market risk and may generate credit risk. The last chapter proposes an original way of integrating credit and market risks in a portfolio model.

The introduction also provides an overview of the book. The chapters are organized to highlight the major topics related to credit risk, such as "Definition and Management" (Chapter 2), "Default and Transition" (Chapters 3 and 4), "Valuation" (including valuation of credit derivatives, Chapters 5-9), "Default Correlation" and "Portfolio Valuation" (Chapters 10 and 11), "Credit Risk in OTC Derivatives Positions" and "Portfolio Risk Measurement" (Chapters 12 and 13). …