Credit risk refers to the uncertainty about whether a counterparty will honor a financial obligation. It is present to some degree in every financial asset and is therefore a central component of portfolio risk. Credit exposure is actively traded, giving rise to indirect credit risk. For example, a commercial bank owning home mortgages can package and sell the cash flows of these mortgages to insurance companies and other financial institutions. A homeowner defaulting on his mortgage obligation to the bank generates indirect credit risk for the insurance company, since the defaulted cash flow is passed through. Similarly, an investment bank can trade credit derivatives that are linked to the default of a corporation on its outstanding bonds. Even if the bank does not own bonds issued by the corporation, its positions in the credit derivatives market gives rise, indirectly, to credit risk. Opportunities for buying and selling indirect credit risk increase the “completeness” of the market by sharing credit risks more widely across investors. On the other hand, trading of indirect credit risk has the potential to exacerbate market failures associated with incomplete information and misaligned incentives.
In recent years there has been increasing attention on and more sophisticated modeling of the credit component of portfolio risk. While a significant fraction of credit risk is driven by market-wide factors, the linear factor modeling approach that dominates equity risk forecasting is not adequate. This is because the relationship between the return to a credit-sensitive instrument and market-wide risk factors is nonlinear. Also, credit-related return distributions tend to be far from normal. As a result, nonlinear models and nonstandard distributions are often used to analyze credit risk. Because of these differences, it remains a challenge to effectively integrate them with factor models and other standard portfolio risk models.
Section 11.1 discusses credit modeling of corporate bonds and describes factor models of spread risk based on agency ratings, sector, and issuer equity. In section 11.2 we look at credit risk models based on historical rating transitions. Section 11.3 sketches some of the