Credit Risk Modeling: Theory and Applications

Credit Risk Modeling: Theory and Applications

Credit Risk Modeling: Theory and Applications

Credit Risk Modeling: Theory and Applications

Synopsis

In this book, two of America's leading economists provide the first integrated treatment of the conceptual, practical, and empirical foundations for credit risk pricing and risk measurement. Masterfully applying theory to practice, Darrell Duffie and Kenneth Singleton model credit risk for the purpose of measuring portfolio risk and pricing defaultable bonds, credit derivatives, and other securities exposed to credit risk. The methodological rigor, scope, and sophistication of their state-of-the-art account is unparalleled, and its singularly in-depth treatment of pricing and credit derivatives further illuminates a problem that has drawn much attention in an era when financial institutions the world over are revising their credit management strategies.


Duffie and Singleton offer critical assessments of alternative approaches to credit-risk modeling, while highlighting the strengths and weaknesses of current practice. Their approach blends in-depth discussions of the conceptual foundations of modeling with extensive analyses of the empirical properties of such credit-related time series as default probabilities, recoveries, ratings transitions, and yield spreads. Both the "structura" and "reduced-form" approaches to pricing defaultable securities are presented, and their comparative fits to historical data are assessed. The authors also provide a comprehensive treatment of the pricing of credit derivatives, including credit swaps, collateralized debt obligations, credit guarantees, lines of credit, and spread options. Not least, they describe certain enhancements to current pricing and management practices that, they argue, will better position financial institutions for future changes in the financial markets.



Credit Risk is an indispensable resource for risk managers, traders or regulators dealing with financial products with a significant credit risk component, as well as for academic researchers and students.

Excerpt

This book provides an integrated treatment of the conceptual, practical, and empirical foundations for modeling credit risk. Among our main goals are the measurement of portfolio risk and the pricing of defaultable bonds, credit derivatives, and other securities exposed to credit risk. The development of models of credit risk is an ongoing process within the financial community, with few established industry standards. In the light of this state of the art, we discuss a variety of alternative approaches to credit risk modeling and provide our own assessments of their relative strengths and weaknesses.

Though credit risk is one source of market risk, the adverse selection and moral hazard inherent in the markets for credit present challenges that are not present (at least to the same degree) with many other forms of market risk. One immediate consequence of this is that reliable systems for pricing credit risk should be a high priority of both trading desks and risk managers. Accordingly, a significant portion of this book is devoted to modeling default and associated recovery processes and to the pricing of credit-sensitive instruments.

With regard to the default process, we blend in-depth discussion of the conceptual foundations of modeling with an extensive discussion of the empirical properties of default probabilities, recoveries, and ratings transitions. We conclude by distinguishing between historical measures of default likelihood and the so-called risk-neutral default probabilities that are used in pricing credit risk.

We then address the pricing of defaultable instruments, beginning with corporate and sovereign bonds. Both the structural and reduced-form approaches to pricing defaultable securities are presented, and their comparative fits to historical data are assessed. This discussion is followed by a comprehensive treatment of the pricing of credit derivatives, including credit swaps, collateralized debt obligations, credit guarantees, and spread options. Finally, certain enhancements to current pricing and management practices that may better position financial institutions for future changes in the financial markets are discussed.

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