Credit Risk: Pricing, Measurement, and Management

Credit Risk: Pricing, Measurement, and Management

Credit Risk: Pricing, Measurement, and Management

Credit Risk: Pricing, Measurement, and Management


Credit risk is today one of the most intensely studied topics in quantitative finance. This book provides an introduction and overview for readers who seek an up-to-date reference to the central problems of the field and to the tools currently used to analyze them. The book is aimed at researchers and students in finance, at quantitative analysts in banks and other financial institutions, and at regulators interested in the modeling aspects of credit risk.

David Lando considers the two broad approaches to credit risk analysis: that based on classical option pricing models on the one hand, and on a direct modeling of the default probability of issuers on the other. He offers insights that can be drawn from each approach and demonstrates that the distinction between the two approaches is not at all clear-cut. The book strikes a fruitful balance between quickly presenting the basic ideas of the models and offering enough detail so readers can derive and implement the models themselves. The discussion of the models and their limitations and five technical appendixes help readers expand and generalize the models themselves or to understand existing generalizations. The book emphasizes models for pricing as well as statistical techniques for estimating their parameters. Applications include rating-based modeling, modeling of dependent defaults, swap- and corporate-yield curve dynamics, credit default swaps, and collateralized debt obligations.


In September 2002 I was fortunate to be on the scientific committee of a conference in Venice devoted to the analysis of corporate default and credit risk modeling in general. The conference put out a call for papers and received close to 100 submissions—an impressive amount for what is only a subfield of financial economics. The homepage, maintained by Greg Gupton, has close to 500 downloadable working papers related to credit risk. In addition to these papers, there are of course a very large number of published papers in this area.

These observations serve two purposes. First, they are the basis of a disclaimer: this book is not an encyclopedic treatment of all contributions to credit risk. I am nervously aware that I must have overlooked important contributions. I hope that the overwhelming amount of material provides some excuse for this. But I have of course also chosen what to emphasize. The most important purpose of the book is to deliver what I think are the central themes of the literature, emphasizing “the basic idea,” or the mathematical structure, one must know to appreciate it. After this, I hope the reader will be better at tackling the literature on his or her own. The second purpose of my introductory statistics is of course to emphasize the increasing popularity of the research area.

The most important reasons for this increase, I think, are found in the financial industry. First, the Basel Committee is in the process of formulating Basel II, the revision of the Basel Capital Accord, which among other things reforms the way in which the solvency requirements for financial institutions are defined and what good risk-management practices are. During this process there has been tremendous focus on what models are really able to do in the credit risk area at this time. Although it is unclear at this point precisely what Basel II will bring, there is little doubt that it will leave more room for financial institutions to develop “internal models” of the risk of their credit exposures. The hope that these models will better account for portfolio effects and direct hedges and therefore in turn lower the capital requirements has led banks to devote a significant proportion of their resources to credit risk modeling efforts. A second factor is the booming market for creditrelated asset-backed securities and credit derivatives which present a new “land of opportunity” for structural finance. The development of these markets is also largely driven by the desire of financial institutions to hedge credit exposures. Finally, with (at least until recently) lower issuance rates for treasury securities and low yields, corporate bond issues have gained increased focus from fund managers.

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